Finance Basic To Advance Level Knowledge

Via the FT's Alphaville we learn that Goldman Sachs is discussing some "radical" options the Fed could use if economic conditions deteriorate further. One of the options discussed is a nominal GDP level target. It would be a radical change from way the Fed currently operates, but such a shock is exactly what the public now needs.  For the past few years the economic outlook of households and firms has been dismal and consequently they have had been accumulating a large stock of money assets .  If the Fed were to announce a nominal GDP level target it would provide a big expectation shock that would reverse much of this buildup.   One of the ways this shock would play out is through the many more observers who would be wailing about the reckless course of monetary policy, the horrors of debasing the dollar, the end of Western Civilization, and other hard money concerns.  Similar concerns were raised when FDR effectively did the same thing in 1933 with his own Q...

Here is the article .  It does a fair job discussing the pros and cons of such a rule.  Among the advantages for NGDP level targeting is that it better handles supply shocks: They could also react more appropriately to supply shocks. Take the example of an economy that is hit by a negative supply shock through high oil prices depressing output and raising inflation. An inflation-targeting central bank may feel compelled to tighten policy, worsening the slump in output, whereas one mandated to hit NGDP could be more flexible. There could be advantages, too, in the opposite case where a positive supply shock through productivity-enhancing new technology boosts real GDP growth while lowering inflation. An inflation-targeting central bank would respond by easing monetary policy, which could produce asset bubbles, whereas an NGDP-targeting central bank would hold steady. Certainly inflation would be more volatile, but the overall economy would not be. One of the disadvan...

I will let the data answer the question.  To do that, I took the Cleveland Fed's monthly 10-year expected inflation rate series and plotted it against the subsequen t growth in nominal consumer expenditures.  I looked at a one, two, and three-year horizons for subsequent consumer spending growth.  Below are the scatterplots created from this exercise. (The data starts in 1982:1 since that is the beginning of the Cleveland Fed's expected inflation series.)  Not only is there a strong relationship, but it gets stronger at longer horizons for consumer expenditures.  So changes in expected inflation do affect nominal spending.  This is nothing new and is a central tenet of modern macroeconomics.  I only bring it up now because some observers have questioned whether there really is this relationship.  Reviewing this relationship also reminds us why it is important for the Fed to be clearer about the future path of monetary policy. Update: I...

Michael Woodford, one of the top monetary theorist in the world, has an Op-Ed today that does a great job explaining why the Fed's policies have failed to gain traction in the economy.  His key point is that the Fed has failed to clearly communicate the path of future monetary policy.  In so doing, the Fed has failed to shape expectations forcefully enough to make a dent in nominal spending.  In other words, the problem is not that the Fed cannot do anything, but that the Fed has failed to act properly.  Woodford says a price level target would solve the problem (and by implication so would a nominal GDP level target) of properly shaping nominal expectations.  Here is Michael Woodford making his point by showing the flaws with the Fed's QE programs: The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan’s experiment with QE, t...

Fortunately, Ramesh Ponnuru is here to clear up the confusion.

A popular explanation for the ongoing economic slump is that the United States is in the midst of a balance sheet recession.  This view holds that the vast amount of household debt built up during the housing boom is now being unwound and that this deleveraging is creating a drag on the economy.  Though intuitive, this balance sheet recession view is inadequate because one, it ignores the potential offset in spending by creditors and two, it misses a more fundamental problem: the elevated demand for liquidity.  I believe one of the reasons for this confusion is that advocates of the balance sheet recession view tend to focus on the liability side of household balance sheets while ignoring the details of the asset side.  A close look at the asset side reveals that despite the collapse in overall household assets, there has been a inordinately large buildup of liquid assets.  It is this accumulation of money and money-like assets rather than the delevera...

Ambrose Evans-Pritchard writes there is still much monetary policy can do to support the economy: [W]ith fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight.  That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman.  To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy. He is referring to this post where I noted the following: [H]ouseholds were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a ba...