Pascal Salin’s Confusion: Inflation or Money Supply Targeting
Pascal Salin critiques Market Monetarism on the grounds that nominal GDP is not a good target. However, his argument is confused. His argument appears to be that a quantity of money rule would lead to stable inflation. And then he correctly recognizes that stable nominal GDP growth is inconsistent with stable inflation when supply-side factors causes changes in real GDP growth.
And then, he becomes confused. Is he criticizing Market Monetarism as being inferior to inflation targeting? Or is he criticizing Market Monetarism as being inferior to targeting some measure of the quantity of money?
Or does he just have no idea what Market Monetarists propose? Why would he suggest that Market Monetarists favor raising money growth to raise inflation on the grounds that this will dampen or reverse a slowdown in real GDP growth due to supply side factors?
In truth, a quantity of money rule does not lead to stable inflation when supply-side factors influence real GDP growth. A quantity of money rule has the exact same consequence as a nominal GDP target in that circumstance. Given velocity, a constant growth rate of the quantity of money leaves nominal GDP on a stable growth path. With both rules, a slow down in real GDP growth due to supply-side factors results in higher inflation.
For inflation to remain stable in the face of a slow down in productivity growth due to supply side factors, the quantity of money must grow more slowly as well. This is exactly the policy required to target inflation.
Market Monetarists argue that slowing money growth when productivity slows due to supply-side factors is unwise in most circumstances. In general, it is better that nominal incomes continue to grow at a stable rate, even if final goods prices rise at a faster rate. Factor prices, like wages, are more stable under quantity of money and nominal GDP level targeting than under a rule targeting inflation in final goods prices.
Since Market Monetarists advocate a rule rather than a discretionary monetary policy, we would argue that a stable growth path for nominal GDP, which is the same thing in this circumstance as a stable growth path for the quantity of money, is the least bad rule. Yes, there could be some supply-side shocks where allowing nominal GDP to vary would have better consequences, and an omniscient and benevolent central banker could do better than targeting the quantity of money or nominal GDP. But we don’t have such a central banker.
But somehow Salin has Market Monetarists proposing to accelerate money growth to cause extra inflation to try to offset the adverse productivity shock. Who knows where that comes from?
So what is the difference between a quantity of money rule and a nominal GDP target? It is the response to shifts in velocity. Market Monetarists believe that the quantity of money should shift in inverse proportion to any shift in velocity. For the most part, this is equivalent to saying that the quantity of money should adjust to accommodate changes in the demand to hold money.
Of course, a quantity of money rule does not allow a change in the quantity of money due to a change in velocity. The quantity of money does not shift in response to changes in the demand to hold money. Rather inflation of final goods prices and factor price like wages change until the real quantity of money adjusts to the demand to hold it. Inflation slows or shifts to a lower growth path, and so real output can be maintained (or recover) despite the lower velocity.
Market Monetarists are fully symmetrical on this matter. We favor restricted money growth when velocity rises, so that inflation does not increase.
Interestingly, the Market Monetarist view of the proper response of policy to shifts in velocity is similar to that of inflation targeting. The only real difference is that Market Monetarists favor a level target–that is a growth path for nominal GDP. Inflation targets a growth rate.
Salin describes the following scenario. The money supply is growing 3%. Real GDP is shrinking 2%, so the inflation rate is 5%. Market Monetarists supposedly would respond to this scenario by having nominal GDP grow 5%. According to Salin, we would anticipate that this would cause real GDP to grow more rapidly (or shrink less,) but he insists that the actual impact would be inflation of 7%.
Well, where did this 3% money growth rate come from?
The 5% nominal GDP target comes from a scenario where the quantity of money is growing 5% and has been for some time. Real GDP usually grows at 3%, resulting in 2% inflation. (This is the high end of Milton Friedman’s proposal for a money supply rule.) Unfortunately, disastrous supply-side policies result in real GDP shrinking 2% a year. The result would be 7% inflation. This would be true whether the money supply target was 5% or the nominal GDP target was 5%. (We can certainly hope that these policies solely lower the growth path of real GDP, so that after a run up in the price level, the inflation rate returns to something like 2%. )
Now, if the growth rate of the money supply had been 3% for some time, then the natural target for nominal GDP growth would also be 3%. Real GDP is usually growing at 3%, and the price level is stable. And then, we have this disastrous productivity shock, and real GDP begins shrinking 2%. The inflation rate is 5%. This is the same result if the quantity of money continued to be targeted at 3% or nominal GDP is targeted at 3%.
Again, we can hope that the adverse policies shift real output to a lower growth path, and then it resumes growing. If real GDP growth permanently slowed down, perhaps to 2%, then after the run up in the price level, inflation would stabilize at 1%.
By the way, Market Monetarists would propose fixing this problem by improved supply-side policies.
An inflation target is somewhat different. To keep inflation stable in the face of real output shrinking 2%, the quantity of money would need to shrink roughly 2%. Market Monetarists think that this would almost always be a horrible policy.
Salin argues that if the money supply remains on a constant growth path, velocity will settle down. From the point of view of Market Monetarists, at first approximation, this would imply that keeping nominal GDP on a stable growth path would require a stable growth path for the quantity of money. We certainly have no problem with that.
One reason Salin claims that velocity fluctuates is due to changes in inflation expectations. However, a nominal GDP target and a quantity of money target generates the same inflation expectations–leaving aside possible changes in velocity. To the degree that changes in the quantity of money can offset changes in velocity and accommodate changes in the demand to hold money, it will reduce fluctuations in inflation and so tend to stabilize inflation expectations and velocity compared to a quantity of money rule.
How do we pick a target for nominal GDP growth? How do you pick a target for the growth rate in the quantity of money? What you do is anticipate the growth rate in real potential output and add to it the inflation rate desired. I go with zero. And so, that results in 3% growth rate for nominal GDP. And that, of course, is the low end for Friedman’s proposal for the growth rate of the quantity of money.
Many Market Monetarists go with the high end of Friedman’s proposal, which is consistent with adding the 3% trend growth rate in real output to the more or less arbitrary 2% inflation target that has been adopted by many central banks. The resulting 5% nominal GDP growth rate happens to be very close to the actual trend growth path of nominal GDP during the Great Moderation. A 5% nominal GDP growth rate seems pretty consistent with the 2% inflation target in the long run.
Salin accuses Market Monetarists of being a sort of new Keynesian. This is because Market Monetarists supposedly believe that raising the inflation rate will reduce unemployment. Salin explains to us that this can at best work in the short run.
I think it is fair to say that most Market Monetarists are especially interested in avoiding an increase in unemployment due to a slowdown in spending on output. While this will also tend to cause some disinflation, what happens to final goods prices isn’t our prime concern. Our view is that by returning spending on output to its trend growth path, there will be a more prompt recovery in output as well as a more prompt reduction in unemployment. That the disinflation might be simultaneously reversed is of little concern. Yes, there might be some reflation along with the recovery in output. And yes, it is all a short run phenomenon.
Suppose the quantity of money was on a 3% growth path, but banking troubles caused the quantity of money to fall 10%. An advocate of a money growth rule would be compelled to support a rapid reversal, with the quantity of money rising roughly 13% to return to its previous growth path.
Now, would that temporary decrease in the quantity of money be associated with a sharp increase in unemployment? Would real output fall? Would there be some disinflation if not outright deflation?
And when the quantity of money recovers, wouldn’t the result be a more prompt recovery of real output and reduction in unemployment? And wouldn’t any disinflation or deflation be reversed?
So, in some sense, there would be temporarily higher inflation associated with a reduction in unemployment. That is all Market Monetarists really have in mind.
The only difference between Market Monetarists and Traditional Monetarists along these lines is that Market Monetarists favor institutions that cause the quantity of money to accommodate shifts in the demand to hold money, or more exactly, that offset shifts in velocity.