George Selgin makes an important point:
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.
In other words, monetary policy should aim to stabilize aggregate demand and not worry about how it breaks down into changes in output and inflation. This has always made sense to me. Why focus on inflation, a symptom of aggregate demand, when one can directly stabilize aggregate demand? Moreover, inflation is at best a sometimes-indicator of aggregate demand since inflation can be contaminated by aggregate supply shocks.
Most macroeconomists, however, are fixated on the inflation-output breakdown of aggregate demand. Selgin considers this to be one of the great diversions in modern macroeconomics.
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.
A great example of how this mischevious belief causes problems can be seen in how the Fed acted in its September, 2008 FOMC meeting. Instead of attempting to stabilize aggregate demand, the Fed was more concerned about balancing the trade-off between growing inflation and falling output. The Fed ignored the forward-looking indicators that were signalling aggregate demand was falling and decided to do nothing. And we all know what happened next.
Maybe one day the Fed will start targeting nominal GDP and do so using nominal GDP futures. What a better world this would be. In the mean time, go read the rest of George Selgin's article.
The current fixation on inflation, even inflation in very low single digits, is inexplicable.
ReplyDeleteThe USA economy did fine from 1982 through 2008 with moderate and varying rates of inflation.
What makes 2 percent inflation magic? What if more-robust long-term growth is obtained with 3 percent inflation? Should we suffocate growth in order to hit the 2 percent inflation target?
Add on, that measuring inflation is difficult.
We should genuflect to a price index that everyone knows is only roughly on target? While people are unemployed? And business lose profits? And the DJIA is stuck at 1999 levels? And property markets are down?