How to Get What Paul Krugman Really Wants

Paul Krugman called for a higher inflation rate at a ECB conference this week. His plea for more inflation is understandable given the failure of the ECB's 2% inflation target to shore up the faltering Eurozone economy. He believes raising the inflation target to 4% will do the trick. But is higher inflation really what he is after?

The answer is no. What he really wants is a foolproof way to ensure there is enough aggregate demand to keep the economy at its full-employment level. He sees a higher inflation target as the way to accomplish this objective. There is another way, though, to achieve his goal without raising the inflation target. To see how it works, let us turn to Israel who was able to keep the growth path of aggregate demand stable during the crisis without changing its inflation target.The figure below shows how the Bank of Israel accomplished this task. It reveals that the central bank temporarily allowed inflation to rise above target when real GDP started falling during the crisis:

By doing this, the Bank of Israel kept total Shekel spending stable as seen in the next figure:

So the Bank of Israel used temporarily higher inflation to offset the decline in real GDP as a way to keep aggregate demand stable. This arguably prevented the Israeli economy from going through the prolonged slumps experienced by the U.S. and Eurozone where this approach was not tried. This nominal stability is what Paul Krugman really wants and it does not require a permanent rise in the inflation rate. It only requires a willingness by the central bank to allow temporary movements in the inflation rate to offset changes in real GDP.

Now the skeptic may question whether the central bank has the ability to do this on a consistent basis. Can a central bank really move the inflation rate in such a timely manner? Maybe the Bank of Israel got lucky. That is a fair point. Fortunately, there is a relatively easy way for a central bank to accomplish this task: target the path of nominal GDP. By doing this the central bank will by default allow temporarily higher inflation when real economic growth slows down and vice versa. This approach will not require the central bank to micromanage the inflation rate--it will automatically adjust. Moreover, by stabilizing total money spending it will also by default be promoting a stable monetary environment where shocks to money demand (or velocity) are offset by changes in money supply and vice versa. This can be seen in the figure below which shows the deviation from trend of velocity and the money supply for Israel:

In short, Paul Krugman can get what he wants without raising the average rate of inflation. Central banks simply have to commit to stabilizing the path of total money spending or nominal GDP. And that is what the Bank of Israels appears to effectively have done over the crisis. The Fed and ECB should take note.

P.S. Evan Soltas was the first person to recognize the Bank of Israel appears to be doing defacto NGDP level targeting