Unintentionally, Kocherlakota makes a strong case for NGDP Level Targeting

In “Blackouts and the Burden of Uncertainty”, he writes:

From the mid-1980s through 2008, central banks had the tools, the will, and the knowledge to protect the economy from sharp swings in the demand for goods and services. They raised interest rates to head off surges, and lowered rates to prevent severe slumps. As a result, households and businesses could count on an economy in which aggregate demand grew relatively steadily. Nobody had to think about, or plan around, the possibility of persistent shortfalls in prices and employment.

That has changed. Since 2008, central banks haven’t been able or willing to defend against a sharp and highly persistent fall in aggregate demand. They have used much of their toolkit, and seem reluctant to employ the tools that remain. As a result, the flow of demand has become uncertain.  Market participants and others are focused on what could go wrong, and how central banks might — or might not — respond.

Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on. After 2008, it became like electricity in India — desperately needed, but subject to random and persistent shortages. Just as the uncertainty of electricity provision hobbles India’s economy, the uncertainty of aggregate demand impairs the global economy. To reduce uncertainty and promote higher growth, both systems need overhauls.

How should the world overhaul its system for providing aggregate demand? To me, this is the key question facing macroeconomists today. Answering it will require a big change in the discipline. Before 2008, most macroeconomists studying the U.S. and Europe largely ignored the possibility of long-lasting shortfalls in demand. This may (at least arguably) have been appropriate for most questions of interest before 2008. Now, however, they need different models and approaches to understand the effects of aggregate-demand uncertainty, and figure out how best to eliminate it.

The chart gives a visual of Kocherlakota´s ‘allegations’.

Note that during 1985 – 2007, NGDP (Aggregate Demand) growth was very stable (comparatively). In other words, “Before 2008, global aggregate demand was like electricity in the U.S. — just something in the background that everyone could count on.”

NK NGDPLT

But note, after 2007 NGDP growth was initially quite unstable, “running off at high speed” through the Southwest corner of the “stability compound”. Contrast that with NGDP “running off at high speed through the Northeast corner of the “stability compound” in 1970 -84. While the 1970s defined the “Great Inflation”, the 2008-09, by symmetry, characterized a strong disinflation period. In 1985 – 07, aggregate demand growth is contained wholly within the “stability circle, and we had the “Great Moderation”.

Again note that contrary to Kocherlakota´s musings, after the “recovery” from the Great Recession was established in early 2010, what we observe is a very stable aggregate demand growth and not random and persistent shortages”.

However, given the low level of NGDP and it´s rather low average growth, the post 2010 period could be called “Depressed Great Moderation”!

From that perspective, again contrary to Kocherlakota, there´s no need to “overhaul the system for providing aggregate demand”, and also no “big change in the discipline” is required.

It is clear that the Fed can target NGDP growth at a stable rate. After all that´s what it did from 1985 to 2007 and from 2010 to 2015. What´s missing now is the definition of an adequate NGDP level and the most promising growth rate along that level path.

If that´s done the economy will, once again, prosper in a state of nominal stability.