In the comment thread to this post by Nick Rowe, Andy Harless brings up Miles Kimball´s twitter answer to my post commenting on his take on NGDP targeting.
Andy Harless: Miles Kimball argues that an NGDP target should be adjusted for productivity growth so as to offset the temporary decline in employment (relative to trend) associated with large increases in productivity.
Nick Rowe: Andy, Miles is (I think) mostly arguing short run, while this post is long run. But even then, I think he’s wrong. If he were right, then IT would prevent recessions (unless the central bank missed the inflation target). The Bank of Canada hit (pretty closely) its inflation target, but we still had a recession.
Bill Woolsey: If final goods prices are sticky, and nominal GDP is on target, then real GDP cannot rise despite improved technology. The result would be an output gap and reduced employment. Real GDP would fail to increase in potential.
The Market Monetarist view (consistent with the productivity norm argument of Selgin) is that when improved technology reduces unit costs, firms will lower their product prices. Prices are not sticky with respect to changes in supply.
As for Kimball’s empirical evidence–what was the monetary regime? Managed gold standard and fixed exchange rates? Targeting the unemployment rate below the natural rate? A planned disinflation? Or, maybe a little bit of all three?
Maybe the “contractionary” impact of technological improvement is independent of the monetary regime, but I doubt it. Of course, if the only purpose of the research is to show that perfectly flexible real business cycle theory doesn’t fit the data, then maybe it works.
Miles argument is relative to a positive productivity shock. He writes:
As long as the natural level of output is growing at a steady rate, keeping real GDP on that steady track will also keep inflation and so the rate of increase of prices steady. If both real GDP and prices are growing at a steady rate, then nominal GDP will be growing at a steady rate. So a steady growth rate of nominal GDP is exactly the right target as long as the natural level of output is growing steadily.
But what if new technology makes the natural level of output go up faster, as the digital revolution did from at least 1995 to 2003? Then real GDP should be going up faster to keep inflation steady. And that means that nominal GDP should also be going up faster. Historically, the Fed has not handled its response to unexpected technology improvements very well, as I discuss in another column, but that doesn’t change the fact that the Fed should have had nominal GDP go up faster after unexpectedly large improvements in technology. (Because the Fed actually let nominal GDP go below trend after technology improvements—instead of above trend as it should have—many people ended up not being able to get jobs after technology improvements.)
I feel very much ‘at home’ in this discussion because I think the 1996-2006 period is the best ‘show-case’ for NGDP level targeting there is.
First, the stylized fact: A dynamic AS/AD model. A productivity shock shifts the AS curve down and to the right. The result is an increase in real growth AND a drop in inflation. In this situation growth is ‘disinflationary’. This goes against the ‘conventional wisdom’ that takes as ‘gospel that growth is inflationary!
Now the ‘real’ facts:
From 1987 to 1995, productivity was growing at an average rate of 1.3%. From 1996 to mid-2003 it went up at a rising rate that averaged 3%, definitively a ‘positive productivity shock’.
As Miles Kimball infers, RGDP should grow faster, And it does. While average RGDP growth was 2.8% from 1987 to 1995, it climbed to an average of 4.4% from 1996 to mid-2000. Unemployment, obviously falls.
But inflation falls as indicated by the AS/AD model with RGDP growing faster. What Miles appears to be saying is that in an inflation targeting framework, to keep inflation on target RGDP should be growing even faster, and that could only be obtained if the Fed increased NGDP. In the AS/AD model, the AD curve should shift up and to the right.
But if the Fed does that, it will impart instability into the system because RGDP growth will rise above ‘potential’ putting pressure on inflation, which will require a policy tightening to contract aggregate demand (NGDP).
And that´s exactly what happened.
The chart illustrates. It is interesting to note that Kimball´s ‘suggestion’ that NGDP growth would have to increase occured. From 1987 to 1995 NGDP was growing close to 5.5% along a level trend path. From 1996 to 2000 it grew by more than 6% on average.
The first chart shows the NGDP ‘gap’ (the difference between NGDP and the trend level path).
It is interesting to observe that in mid-97 many were worried about an overheating economy. At that moment Krugman was on the opposite side of the ‘fence’, clamoring that the economy had a well-defined ‘speed-limit’ (about 2.25%) and since it was growing at more than 4% inflation was ‘right around the corner’ and Greenspan ‘behind the curve’:
Most economists believe that the US economy is currently very close to, if not actually above, its maximum sustainable level of employment and capacity utilization. If they are right, from this point onwards growth will have to come from increases either in productivity (that is, in the volume of output per worker) or in the size of the potential work force; and official statistics show both productivity and the workforce growing sluggishly. So standard economic analysis suggests that we cannot look forward to growth at a rate of much more than 2 percent over the next few years. And if we – or more precisely the Federal Reserve – try to force faster growth by keeping interest rates low, the main result will merely be a return to the bad old days of serious inflation.
For a while, Greenspan held the contrarian view that the economy was experiencing a productivity surge (the data was still not available) so the Fed had to move cautiously. When the Russia/LTCM shock hit rates were brought down only to begin rising shortly after due to ‘exuberant growth’ and an unemployment rate that was ‘too low’.
The economy tumbled and rates were brought down in rapid succession. But things only showed improvement, in the sense of NGDP climbing back towards trend when the Fed introduced ‘forward guidance in August 2003.
By the time Greenspan left the Fed NGDP was back on trend. But then we witness the sad story of Bernanke´s stewardship, characterized by NGDP systematically below and distancing itself from the trend level path. It is very possible, even likely, that the ‘Lehman Affair’ was a direct consequence of the spending shortfall!
The promised charts for the 1996 – 2003 period.
I have no doubt that Kimball´s conjecture is wrong! A stable NGDP trend path is what´s required at all times.
HT Bill Woolsey
Historinhas 
Great analysis.
Great job! Love the going back to 1997 to show your point.
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“What Miles appears to be saying is that in an inflation targeting framework, to keep inflation on target RGDP should be growing even faster, and that could only be obtained if the Fed increased NGDP. In the AS/AD model, the AD curve should shift up and to the right.
But if the Fed does that, it will impart instability into the system because RGDP growth will rise above ‘potential’ putting pressure on inflation, which will require a policy tightening to contract aggregate demand (NGDP).”
I don’t think this is what happens in Miles’ model. I think his view is that “potential” RGDP growth is always close to the rate that would be consistent with a constant inflation rate — IOW a positive productivity shock induces a larger shift in the LRAS curve than in the SRAS curve, so unless you shift the AD curve in response, you end up temporarily below potential. (He argues this is true because of sticky prices, and I still have to think through the argument and counterargument.)
The evidence from the post-1996 episode could be taken either way. One the one hand, the Fed did allow NGDP to rise above trend. On the other hand, it allowed the core price level to fall below trend. It essentially split the difference between what you would recommend and what Miles would recommend, so either of you can claim that subsequent instability was the result of the Fed’s failure to follow your preferred policy.
Personally I think, even if Miles is right, that the advantages of NGDP level targeting over inflation targeting outweigh the disadvantages, and the simplicity of a fixed NGDP target is enough of an advantage to outweigh the possible short-run advantage of one that adjusts for supply shocks, but I think Miles’ concern is one that needs to be taken seriously and thought through.
Andy, You wrote: “I don’t think this is what happens in Miles’ model. I think his view is that “potential” RGDP growth is always close to the rate that would be consistent with a constant inflation rate — IOW a positive productivity shock induces a larger shift in the LRAS curve than in the SRAS curve, so unless you shift the AD curve in response, you end up temporarily below potential. (He argues this is true because of sticky prices, and I still have to think through the argument and counterargument.)”
Let´s assume that the LRAS shifht right by more than the SRAS. That means that in the ‘long-run equilibrium’ inflation will be a lower constant rate than before the shock. I take Miles implies that inflation should remain at the ‘old’ rate, in which case he argues that AD has to shift right. That´s true if you operate a symetric inflation targeting regime. And my contention is that such a regime brings instability in the case of supply shocks.
The LRAS curve is (according to the textbook view, though it is somewhat discredited over the past couple of years) vertical. So if it shifts further than the SRAS curve, this has no implication about the long run inflation rate, since any inflation rate is consistent with a vertical LRAS curve. But Miles is saying, if you want to stay on the LRAS curve (i.e. at potential), you have to move up the new SRAS curve, and this requires an AD shift. (On your chart, the old LRAS curve would be a vertical line through point 1, and the new LRAS curve would be a vertical line that crosses AS2 at a point directly to the right of point 1.)
Andy, I get that. My point is that by keeping NGDP on an ‘even keel’ you´ll get to the new LRAS curve (the SRAS will be shifting right as long as Y is below potential). My take: Don´t fiddle with AD because you´ll likely destabilize. Further, if you keep AD growing at the ‘trend’ rate inflation will come down. That´s the better world: higher gowth (=higher potential) AND lower long-run inflation.
So your view is that inflation targeting constitutes “fine tuning,” and policymakers aren’t likely to do a good job at it.
I would put it this way: It´s the wrong target to fine-tune. They did a good job at it but it was clearly the wrong target once inflation was ‘conquered’.
“First, the stylized fact: A dynamic AS/AD model. A productivity shock shifts the AS curve down and to the right. The result is an increase in real growth AND a drop in inflation. In this situation growth is ‘disinflationary’. This goes against the ‘conventional wisdom’ that takes as ‘gospel that growth is inflationary!”
It depends on if it’s supply or demand side doesn’t it?
“But inflation falls as indicated by the AS/AD model with RGDP growing faster. What Miles appears to be saying is that in an inflation targeting framework, to keep inflation on target RGDP should be growing even faster, and that could only be obtained if the Fed increased NGDP. In the AS/AD model, the AD curve should shift up and to the right.”
“But if the Fed does that, it will impart instability into the system because RGDP growth will rise above ‘potential’ putting pressure on inflation, which will require a policy tightening to contract aggregate demand (NGDP).”
But if the increase in growth is supply side why should there be a need to tighten?
Mike, MK is saying the Fed has to ease, not tighten! If it eases it will have to tighten later. That´s how the instability takes hold..
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