Bank of Canada Governor Mark Carney recently gave a speech on monetary policy, where among other things, he discussed price level and nominal GDP targeting. In that speech, he made the following remark:
In addition, under NGDP-level targeting, the central bank would seek to stabilize the GDP deflator in order to achieve price stability. But the GDP deflator measures the price level of domestically produced goods and services, which may not match up well with the cost of living that the CPI measures and that matters most for welfare, particularly in small, open economies where imports make up a substantial share of the consumption basket.
Contrary to others, such as Scott Sumner, I don’t see this as a ridiculous statement. This post is my attempt to explain why.
To assess Carney’s claim, we need to answer a simple question. What measure of the price level should we want to stabilize? To answer this question, we will think about money purely as a medium of account. In doing so, I can hopefully demonstrate that Carney’s statement is entirely consistent with my argument.
Consider an individual with a utility function, , where measures the consumption of good i at time t. Now let’s suppose that consumption for this individual is fixed for all future periods, t = t+1, t+2, … We can thus confine our attention to the present decision. Consider changes in . Some of the changes in the composition of the basket of goods will not affect utility, whereas others will. The individual will choose the composition of his basket by choosing the combination that maximizes utility subject to his budget constraint.
This basic application of consumer choice theory poses what is called an index number problem. Namely, the question is what price or combination of prices has to be held constant in order to prevent resource misallocation due to inflation. In other words, how should we deflate money income in the consumer choice problem when inflation occurs? Put succinctly, the solution is to identify the price index for which real income remains constant as we move along the indifference surface. Another way of saying this is that, for a given indifference surface, it is possible to adjust the price level to maintain constant money income. The absolute price level that corresponds with this condition could be found for every single point along an indifference surface. Thus, it would be optimal for monetary policy to choose the quantity of money to achieve the price level that would maintain constant money income.
So what does this mean in terms of Carney’s comments? Basically, it means that the construction of an appropriate price index should include the prices of goods that are in the individual’s utility function. Thus, for a small open economy, the appropriate price index to target is likely that which includes imports. The GDP deflator might be inappropriate.
This may or may not be a good way to think about monetary policy, but I think that it does demonstrate that Carney’s distinction is grounded in economic theory.
Also, just so Scott is happy, I should note that if the central bank were to target the properly constructed price index, money income would be the appropriate measure of welfare (because money income would be monotonically related to utility).
[For more on the index number problem, see Jurg Niehans's, The Theory of Money. What is presented above is largely a (terse) summary of what I remember discussed in that text.]
**Note: “Money is here called a medium and not, as customary, a unit of account because, clearly, money itself is not a unit, but the good whose unit is used as the unit of account.” (Niehans, 1978, p. 118n)