Tuesday, May 6, 2014

The Seesaw Approach to Monetary Policy

In my last post, I made the following comment:
A NGDP target aims to stabilize total dollar spending. It is one target that has embedded in it both the supply of and the demand for money (i.e. total dollar spending = money supply x velocity of money). The beauty of a NGDP target is that the Fed does not need to know what is exactly happening to the money supply or money demand. All the Fed only needs to worry about is the product of the two components. There is no need to track the money supply or estimate money demand. By focusing on total dollar spending, the Fed will be fostering a stable monetary environment where movements in money supply and money demand are offsetting each other.
Another way of saying this is that by targeting the growth path of NGDP, the Fed will be taking a seesaw approach to monetary stability. That is, endogenous changes in the money supply will be automatically offset by changes in money velocity and vice versa. This is illustrated below:

Now to be clear, most money is inside money--money endogenously created by banks and other financial firms--and the Fed only indirectly influences its creation. However, it does so in an important way by shaping the macroeconomic environment in which money gets created. Consequently, it can have a large influence on inside money creation. For the same reason it can also influence how stable is the velocity of money. By successfully stabilizing the expected growth path of total dollar spending, the Fed will be causing this seesaw process to work properly.

Here is the interesting thing. Even though the Fed was not officially targeting NGDP, it effectively seem to be practicing the seesaw approach to monetary policy over much of the Great Moderation period. This can be seen in the figure below which shows the growth rate of Divisia M4- money supply and the growth rate of its velocity. Note how these two series tend to offset each other as implied by the seesaw approach:

Now note the area in the the grey bar. During this time the figure shows there was no offsetting movements. The money supply and velocity both fell--the seesaw process was broken. It was during this time that the Fed failed to stabilize total dollar spending and this allowed the emergence of the Great Recession.

One way, then, to view the Fed's job is that it should aim to keep the monetary seesaw process working properly. For a long time it did that, but failed spectacularly in 2008-2009. It would be whole lot easier going forward if the Fed explicitly adopted a NGDP level target.

P.S. The seesaw process is another way of looking at Milton Friedman's Thermostat Approach to monetary policy, as noted by Nick Rowe.


  1. David
    I hope the "embroidering" does not offend:

    1. Marcus, that is fine. Nice use of the monthly GDP data. And your NGDP gap, it is huge. I came up with something similar using a pre-2007 trend. The question I have does it still make sense to do this trend this far out?

    2. No, it doesn´t. But I had to keep to the original trend just to show the 'hugeness' of the MP mistake. Most likely the new level path is below the 'old one' (hysteresis and all that).

  2. That's a really interesting chart there David.

  3. Great blogging. Yes, at this point the Fed has inflicted permanent damage on the economy, so now it can we are closer to full potential.

  4. David,

    Great post and fascinating chart. As an NGDP targeting proponent, how do you answer the charge that the implicit strategy worked for a quarter century ....and then the minute the Fed stopped "following it", a massive recession commences (given the coincidence of their "abandonment" of the implicit NGDP target and the recession itself)? To say this differently, wouldn't continuation of the NGDP targeting have led to more houses being built that no one could afford, so to speak?
    JLC (sorry, I have not figured out how to set up my name here yet like Benjamin and Tom Brown above)

    1. This comment has been removed by the author.

    2. JLC,

      Had the Fed been able to keep NGDP growth stable there still would have been a housing recession, just not a Great Recession. In other words, keeping total spending stable still does not stop some sectors from contracting. It just stops the sectoral recession (in this case housing) from spreading to the rest of the economy. One can have stable total dollar spending growth and still have productive reallocation of resources in an economy.

      In fact, this more or less what the Fed did for two years leading up to the sharp collapse in late 2008. A housing recession started in early 2006 and continued for almost two years without adversely affecting the rest of the economy. During this time the Fed was doing a decent job (absent its credit market intervention) keeping total money spending stable. It was only in mid-2008 when the Fed slipped. See this post for more on this argument: