The sure-fire way of stabilizing the real economy or, “all roads lead to Rome”

At Vox, Walentin and Westermark write, “Stabilising the real economy increases average output”:

The intro:

The Great Recession has generated a debate regarding the potential effects on the long-run levels of output and unemployment of stabilising the real economy (e.g. Summers 2015). This issue takes on additional importance as the current economic situation in some countries, including the US, imply that there is a monetary policy trade-off between stabilising inflation and the real economy.

In particular, the unemployment level is low at the same time as inflation is low. More generally, the question at hand is whether policymakers, in particular central bankers, should try to stabilise the real economy, beyond taking into account how real factors affect inflation.

In this column, we will shed light on this question by summarising research indicating that stabilising the real economy raises the long-run level of output.


In sum, both empirical and theoretical arguments increasingly indicate that output and unemployment volatility reduces output and thereby impose substantial costs to society.

This is a solid argument in favour of policies that stabilise output and unemployment, in addition to inflation (see Lepetit 2017 for a quantitative treatment).

That said, we should not underestimate the various challenges that both fiscal and monetary policy face when attempting to stabilise the real economy.

For example, there are substantial practical difficulties in measuring what output trend or unemployment level the economy should optimally be stabilised around. Nevertheless, recent advances in economic modelling tilts the policy conclusion towards stabilising the real economy more than previous research has motivated.

Interestingly, in the late 1970s, John Taylor suggested an alternative set of options for policymakers to consider, one consistent with macroeconomic theory. These alternative options involve a tradeoff between the variability of output and the variability of inflation.

[Taylor, John B. “Estimation and Control of a Macroeconomic Model with Rational Expectations,” Econometrica, 47 (5), 1979, pp. 1267-86.]

In 2004, Bernanke gave a speech titled The Great Moderation. His conclusion:

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development.

Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed.

I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well.

Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks.

This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

What all the above quotes are saying is that the Fed should “calibrate” monetary policy to obtain both inflation and real growth stability. What they miss is that stabilizing both inflation and real growth is synonymous to stabilizing the nominal economy, i.e., NGDP!

Bernanke puts up a version of the chart below to illustrate the shift from the “Great Inflation” (GI) to the “Great Moderation” (GM).

The chart also indicates that the “Great Recession” (GR) entailed a loss of real growth stability, while inflation stability was maintained.

Does real world data conform to the idea that to stabilize both inflation and the real economy the Fed has to stabilize NGDP?

To illustrate I construct phase-space charts. These charts illustrate volatility (or variance) through a scatter plot of percent changes (in nominal and real growth, inflation and unemployment) at time t and time (t+1). The more closely together that dots are bunched, the lower that volatility or variance of changes.

The first panel depicts the volatilities during the “Great Moderation”. The ellipses delimit the range of variation for nominal and real growth, inflation and the unemployment rate.

The second panel shows what happened during the “Great Inflation” (GI). The ellipses are those obtained from the GM period. During the GI, while NGDP growth shows a rising trend, real growth is just more volatile, while inflation also shows a rising trend. Unemployment is generally higher and more volatile.

The next panel shows the GR period. Nominal growth “escapes” the “stability ellipse” through the southwest “door”. In other words, nominal growth tumbles. Real growth follows suite, while inflation remains “trapped” inside the stability ellipse, and close to the points that prevailed during 1994-05. Unemployment skyrockets.

Three observations:

  1. Does stabilizing the real economy increase average growth, as Walentin and Westermark argue? If that were so, you should expect that real growth during the GM would be higher than during the GI.

That, however, is not true. During the GM, average growth was 3.2%, with a standard deviation (volatility) of 1.4. During the GI, average growth was almost the same at 3.3% but volatility was double, 2.8.

  1. There doesn’t appear to be a trade-off between inflation and real growth stability. By abandoning nominal stability, the Fed may lose both inflation and real stability, like in the 70s, or just real stability as during the GR.
  2. Bernanke was confident that monetary policymakers would not forget the lessons of the 1970s. That was the problem, because thinking in terms of the wrong lesson, the Fed “forgot” that the real lesson was the one provided by the GM i.e., keep NGDP growth stable.

The last panel shows variances for the post GR period. Nominal stability was regained, leading to stability in the real economy (RGDP & unemployment) and inflation.

Note, however, that the stable growth of NGDP in the aftermath of the GR is significantly lower than the stable growth rate observed during the GM. The average growth of real output is also significantly lower. Meanwhile, inflation is equivalently low and stable while the unemployment rate has converged inside the GM ellipse.

That is why, despite positive and stable real growth, the economy appears sickly. This is where the idea of “level targeting”, as in NGDP-LT becomes important.

We saw that during the GR, NGDP growth tumbled. Thereafter, its growth remained too low (although stable) to bring NGDP to the previous level path. The level chart below illustrates.

The fact that monetary policy is conducted according to “imaginary numbers” (Potential output, Natural Rate of unemployment, Neutral Rate of interest), is “depressing”. For example, Atlanta Fed president Raphael Bostic recently argued against the Fed adopting an NGDP targeting framework because it is conditional on potential output.

In a recent speech, San Francisco Fed president John Williams says:

An important development of the past decade is that the trend growth rate today appears to be considerably slower than the growth trends we’ve previously seen in our lifetimes. This slower pace of growth is a reflection of a sharp decline in labor force growth and relatively slow productivity growth.

… Given that the current pace of growth is above trend, my view is that we need to continue on the path of raising interest rates. This will keep things on an even footing and reduce the risk of us getting to a point where the economy could overheat, and create problems that could end badly.

What Bostic and Williams are in fact saying is that we have to keep the economy depressed so as not to stoke inflation, additional Fed tightening, and recession!

The next panel is interesting, making clear the uselessness of the concept of potential output. During the GM, estimates of potential were systematically revised up to converge on actual output. Since the GR, potential output has been systematically revised down to converge on actual output. All the while, inflation first came down and then remained low and stable.

What if labor force and productivity growth are significantly determined by the “robustness” of real growth? Given that potential output appears “conditioned” on actual output, raising the level and growth rate of real output, through a higher level of NGDP and NGDP growth could do wonders for the economy.

That may have been what Yellen had in mind a couple of years ago when she conjectured about running the economy hot for a time. Unfortunately, she never tried.

Bottom line: “All roads lead to Rome” i.e., to NGDP level targeting.


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