Money as Medium of Account

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)

Self-Recommending

PBS has a forthcoming special entitled, “Testing Milton Friedman” due to premier later this year. Here is a preview and here is a list of participants in the debate.

Nominal Income and the Great Moderation

The period from 1984 through 2007 was one that exhibited a marked decline in macroeconomic volatility. As such, it is commonly referred to as the Great Moderation. This period has potentially important implications for policy. If, for example, the reduction in volatility was the result of smaller “exogenous shocks” to the economy, then we can largely view the period as one of good luck. However, if the reduction in volatility can be linked to a change in policy, then this period can potentially provide guidance as to how policy should be conducted in the future.

A subset of the literature on the Great Moderation suggests that the reduction in volatility can be explained by a change in monetary policy. In particular, this research largely suggests that the change in monetary policy during the Great Moderation was the Federal Reserve’s commitment to the Taylor principle. Put succinctly, the Taylor principle refers to the idea in which the central bank raises the nominal interest rate more than one-for-one with realized inflation. In other words, the central bank increases the real interest in response to higher realized inflation.

In a new paper, which is forthcoming in the Journal of Macroeconomics, I argue that monetary policy was in fact an important factor in reducing macroeconomic volatility. However, I present an alternative view of the behavior or monetary policy and explicitly reject what I call the “Taylor view.” Specifically, in the paper I make the following argument:

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was an overhaul of Federal Reserve doctrine. The radical change in monetary policy was that the Federal Reserve placed emphasis on the role of inflation expectations, knowing that if inflation expectations were stabilized, the price system would restore full employment. The mechanism through which the Federal Reserve sought to achieve this goal was in maintaining low, stable rates of nominal income growth. The commitment to a low, stable rate of nominal income growth regardless of fluctuations in output and employment would give the central bank credibility and therefore stabilize inflation expectations. Full employment was left to the price system.

This understanding of the change in policy is in sharp contrast to the Taylor view. As I argue in the paper, during the Great Inflation period of the 1970s, members of the FOMC regularly asserted that the process of inflation determination had changed. Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation. The Fed simply assumed accountability as the creator of inflation.

In addition to examining public statements, I empirically test the hypothesis that the Federal Reserve became more responsive to their forecasts of nominal GDP growth beginning with Paul Volcker. In addition, using simulations (based on simple, conventional sticky-price models), I demonstrate that a monetary policy rule based on the estimated response to these forecasts can potentially explain the reduction in macroeconomic volatility observed during the Great Moderation.

For those interested, a link to the working paper version of the paper can be found here. (The link is a viewable link. To download the paper, go here.)