It's hard to figure out how to fix the world if you don't have a reliable model that can explain what went wrong. The optimal money rule in a model depends upon the the way in which changes in monetary policy are transmitted to the real economy. Is it because of price rigidities? Wage rigidities? Information problems? Credit frictions and rationing? The best response to a negative shock to the economy varies depending upon what type of model the investigator is using.
Thus, for the moment we need robust rules. Inflation targeting works well in models with Calvo type price-rigidities, and a Taylor type rule often emerges from models in this general class, but is this the most robust rule in the face of model uncertainty? We don't know the true model of the macroeconomy, that ought to be clear at this point. Does inflation targeting work well when the underlying problem is a breakdown in financial intermediation or other big problems in the financial sector? I'm not at all convinced that it does - some of the best remedies in this case involve abandoning a strict adherence to an inflation target in the short-run.
So, in the best of all worlds I'd prefer to have a model of the economy that works, find the optimal policy rule for that model, and then execute it. In the world we live in, I want robust rules -- rules that work well in a variety of models and in the face of a variety of different types of shocks (or at least recognize that the rule has to change when the source of the problem switches from, say, price rigidities to a breakdown in financial intermediation). One message that comes out of the description of NGDP targeting above is that this approach does appear to be more robust than inflation targeting. It's not always better, in some models a standard Taylor type rule is the best that can be done. But it's becoming harder and harder to believe that the Great Recession can be adequately described by models of this type, and hence hard to believe that we are well served by policy rules that assume price rigidities are the main source of economic fluctuations.Read it at Economist's View
"Inflation Targeting is Dead"
by Mark Thoma
Everything but the obvious. Hint — try Godley stock-flow consistent macro modeling and fiscal rules (functional finance). Monetary policy is dead because Monetarism is moribund. Love live fiscal! Post Keynesianism rules.
15 comments:
What’s all this Mark Thoma type pseudo scientific waffle: “reliable models”, “optimal money rules”, “price ridgities”, “informational problems”? And that’s just from the first paragraph above. The pseudo scientific waffle continues in the subsequent paragraphs.
The Bank of England abandoned inflation targeting a few years ago because it thought, quite rightly, that inflation in the last couple of years was cost push rather than demand pull. Thus there would have been no point in raising interest rates because it would not have influenced inflation.
There you are. The case against inflation targeting can be made by using common sense and plain simple English.
Should read: "Monetarism is dead."
Nick Rowe made it clear that monetary policy works through magic, remember?
Ralph Musgrave,
What makes you say the BoE has abandoned inflation targetting? Any evidence to support this claim?
The BoE has indeed abandoned inflation targeting, but not for the reasons that Ralph gives. It has abandoned IT because it's obvious that it is no longer an optimal policy.
"It's hard to figure out how to fix the world if you don't have a reliable model that can explain what went wrong."
Baby Steps.
"So, in the best of all worlds I'd prefer to have a model of the economy that works, find the optimal policy rule for that model, and then execute it. In the world we live in, I want robust rules "
Almost an admission that a return to realistic models based on tangible measurements and outcomes is desirable.
The future of fairies, forces and expectations in economics looks dimmer every day. Pity.
"The BoE has indeed abandoned inflation targeting, but not for the reasons that Ralph gives. It has abandoned IT because it's obvious that it is no longer an optimal policy."
So what is the BoE's policy now?
Try to put out the fires as and when they discover them.
what does that mean?
They still have a target inflation range, still think that raising interest rates reduces inflation and lowering rates increases inflation, don't they?
I don't think that there have been any official changes to the Bank's monetary framework. In practice, however, they have abandoned IT, and are not setting the policy rate with an inflation target in mind.
There's a broad consensus around this BTW, that is not limited to the Bank--hence Thoma's post.
So the BoE's now thinking in terms of NGDP targeting?
If the Bank were thinking about a targeting rule, it would be an inflation target, not an NGDP target, but it is not thinking about any kind of targeting rule. Instead, it's thinking about how to shield the UK economy from the conflagration in Europe.
The Bank of England think (read knows) that if it were to hike interest rates, it will put the household sector in great trouble because households in Britain are highly indebted and the burden of the debt is highly sensitive to interest rates.
Even if households can manage, they will have to reduce consumption and this can have terrible consequences.
http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp450.pdf
and
http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp441.pdf
and
http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp432.pdf
"Indeed, if we are to control three major macroeconomic dimensions of the economy, namely the inflation rate, the unemployment rate, and the growth rate, a third control is needed that will be reasonably non-collinear in its effects to those of a fiscal policy operating through disposable income generation on the one hand, and monetary policy operating through interest rates on the other.
What may be needed is a method of directly controlling inflation that do not interfere with free market adjustments in relative prices or rely on unemployment to keep inflation in check. Without such a control, unanticipated changes in the rate of inflation, either up or down, will continue to plague the economy and make planning for investment difficult. Trying to control an economy in three major macroeconomic dimensions with only two instruments is like trying to fly an airplane with elevator and rudder but no ailerons; in calm weather and with sufficient dihedral one can manage if turns are made very gingerly, but trying to land in a cross-wind is likely to produce a crash.
One possible third control measure would be a system of marketable rights to value added..."
http://www.columbia.edu/dlc/wp/econ/vickrey.html
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