Price-Level Movements, Fixed Nominal Contracts, and Debtor-Creditor Equity

nominal GDP, NGDP Targeting, price level, monetary economics, Great Recession

Recently David Beckworth and Martin Sandbu, among others, have drawn attention to an interesting paper by James Bullard and Riccardo DiCecio unveiled in Norway earlier this year. In it, Bullard and DiCecio investigate a model economy possessing both a large private credit market and "Non-state contingent nominal contracting (NSCNC)." They conclude that, in such an economy, NGDP targeting is the "optimal monetary policy for the masses."

Here is David Beckworth's intuitive explanation for that finding:

The basic idea is that in a world of fixed-price nominal debt contracts (i.e. the real world), a NGDP level target provides better risk sharing among creditors and debtors against economic shocks than does a price stability target.

This is because a NGDP level target makes inflation countercyclical. During recessions, inflation rises and causes creditors to bear some of the unexpected pain by lowering the real debt payments they receive from debtors. During booms, inflation falls and allows creditors to share in some of the unexpected gain by increasing the real debt payments they receive from debtors. Debtors, in other words, bear less risk during recessions but also share unexpected gains during expansions.

NGDP level targeting, in other words, causes a fixed-price nominal debt world to look and feel a lot like an equity-world. In a similar spirit, some observers have called for a risk-sharing mortgages as a way to avoid another Great Recession. The point of this paper is that the same benefit that such risk-sharing mortgages would bring can be had by having a central bank target the growth path of NGDP.

Although Bullard and DiCecio's specific argument is novel, the idea that fluctuations in the general price level can actually contribute to optimal risk sharing in a world of fixed nominal debts is itself by no means knew. Bullard and DiCecio themselves refer to previous work making the same basic argument by Evan Koenig and Kevin Sheedy , while in my previous article here I traced the idea all the way back to Samuel Bailey's (1837) classic monograph, Money and its Vicissitudes in Value.

I myself first cottoned-on to the view that what's now called NGDP targeting is more conducive to what economists nowadays call achieving optimal risk sharing in a world with many fixed nominal debt contracts (but which used to be called avoiding "debtor-creditor injustice") while working on my PhD dissertation in the early 1980s. Back then I still didn't know about Bailey, though I did discover a few other works — all written some years before — supporting my perspective.

My conclusions eventually found their way into my dissertation, and thence into my first (1988) book, The Theory of Free Banking. I later expanded and refined them in Less than Zero (1997, especially pp. 41-5; new edition forthcoming!). Because my earlier discussion is especially informal and intuitive, I thought that persons interested in more recent works addressing the same issue, like those of Koenig, Sheedy, and Bullard and DiCecio, might find it of interest, if not helpful to their  understanding of these much more sophisticated works. So here it is, with no changes save (1) the addition of a new note; (2) the removal of two original notes that contained references only; and (3) the insertion of ellipses in place of a phrase that would seem meaningless here, where it has been stripped of its context.


To address the problem of debtor-creditor injustice, one must first understand how different kinds of price changes actually affect the well-being of parties on either side of a debt contract. One also has to have a definition of injustice. For the latter we may adopt the following: parties to a long-term debt contract may be said to be victims of injustice caused by price-level changes if, when the debt matures, either (a) the debtors on average find their real burden of repayment greater than what they anticipated at the time of the original contract and creditors find the real value of the sums repaid to them greater on average than what they anticipated; or (b) the creditors find the real value of the sums repaid to them smaller on average than what they anticipated and debtors find their real burden of repayment smaller than what they anticipated at the time of the original contract. When injustice occurs the parties to the debt contract, if they had had perfect foresight, would have contracted at a nominal rate of interest different from the one actually chosen.

It is not always appreciated that not all movements in the general level of prices involve injustice to debtors or creditors. Unanticipated general price movements associated with changes in per-capita output…do not affect the fortunes of debtors and creditors in the same, unambiguous way as do unanticipated price movements associated with monetary disequilibrium.* Where price movements are due to changes in per-capita output, it is not possible to conclude that unanticipated price reductions favor creditors at the expense of debtors. Nor can it be demonstrated that unanticipated price increases favor debtors at the expense of creditors. The standard argument that unanticipated price changes are a cause of injustice is only applicable to price changes caused by unwarranted changes in money supply or by unaccommodated changes in money demand.

This is so because in one of the cases being considered aggregate per-capita output is changing, whereas in the other it is stationary. In both cases a fall in prices increases the value of the monetary unit and increases the overall burden of indebtedness, whereas a rise in prices reduces the overall burden, other things being equal. In the case where per-capita output is stationary (the monetary disequilibrium case), the analysis need go no further, and it is possible to conclude that falling prices injure debtors and help creditors and vice versa. Were parties to long-term debt contracts able to perfectly anticipate price-movements, they would, in anticipation of higher prices, contract at higher nominal rates of interest; in anticipation of lower prices they would contract at lower nominal rates of interest. In the first case the ordinary real rate of interest is increased by an inflation premium; in the latter, it is reduced by a deflation discount. These adjustments of interest rates to anticipated depreciation or appreciation of the monetary unit are named the “Fisher” effect, after Irving Fisher who discussed them in an article written just before the turn of the century.

When per-capita output is changing, one must take into account, in addition to the Fisher effect, any intertemporal-substitution effect associated with changes in anticipated availability of future real income. Here (assuming no monetary disequilibrium) reduced prices are a consequence of increased real income, and increased prices are a consequence of reduced real income. Taking the former case, although the real value of long-term debts increases, debtors do not necessarily face a greater real burden of repayment since (on average) their real income has also risen. In nominal terms they are also not affected because, as distinct from the case of falling prices due to a shortage of money, their nominal income is unchanged. Thus debtors need not suffer any overall hardship: the damage done by the unanticipated fall in prices may be compensated by the advantage provided by the unanticipated growth of real income. If the parties to the debt contract had in this situation actually negotiated with the help of perfect foresight, their anticipation of reduced prices would have caused the nominal rate of interest to be reduced by a deflation discount — the Fisher effect. But their anticipation of increased real income would also reduce their valuations of future income relative to present income, raising the real component of the nominal rate of interest — the intertemporal-substitution effect. Since the Fisher effect and the intertemporal substitution effect work in opposite directions it is not clear that the perfect-foresight loan agreement would have differed from the one reached in the absence of perfect foresight — at least, the direction in which it would have differed is not obvious. So there is no reason to conclude that a monetary policy that permits prices to fall in response to increased production would prejudice the interests of debtors.

Similarly, to allow prices to rise in response to reduced per-capita output would not result in any necessary injustice to creditors, even if the price increases were not anticipated. Here the Fisher effect in a perfect-foresight agreement would be positive, and the intertemporal substitution effect would be negative, so it cannot be said a priori that the perfect-foresight nominal rate of interest would differ from the rate agreed upon in the absence of perfect foresight.


*By "monetary disequilibrium" I mean unanticipated changes in nominal spending (MV or, equivalently, Py). Earlier in my book I explain that a monetary policy "that maintains monetary equilibrium [is one] that prevents price changes due to changes in the demand for money relative to income without preventing price changes due to changes in productive efficiency." I would have chosen my terms more carefully had I known better.