What is the Purpose of Macroeconomic Policy?
All human institutions exist to improve the lives of someone, in the abstract, but each has its own abilities which can be used to solve particular problems. In other words, the means of an institution drives the ends to which it is used. Central banks can print new money and use that money to buy government bonds. They can use that ability to change the ratio of base money to government bonds in the economy and hence increase or decrease the rate of spending. Likewise, the government can borrow and spend directly, which many economists believe can also increase the rate of spending. But ultimately, whether thru fiscal or monetary policy, macroeconomic policy is able to adjust aggregate demand (AD).
Speed of Price Adjustment
Because prices are somewhat sticky, aggregate demand policy has an impact on relative prices: slowly adjusting prices are too high relative to quickly adjusting prices in times of decreasing AD and vice versa in times of increasing AD. Wages, being slow to change relative to many other goods, tend to be too high during recessions for the employment market to clear (in other words, unemployment is too high). Given that markets for goods with quickly adjusting prices clear almost no matter what monetary policy is, perhaps AD policy should focus on stabilizing prices of goods which are most costly to adjust. If policymakers cannot observe which prices are stickiest, or if adjustment costs vary over time, it is perhaps best to target a broad index of prices rather than trying to micromanage which prices specifically to target.
Relative Importance of Disequlibrium
Another factor to consider is which prices cause the most harm when incorrect? If the price of a good is not equal to the free market equilibrium, there will be either a shortage or surplus of the good and in either case, there are welfare losses to society. But not all goods are equally important. Once again, wages stand out as an important target, because when wages are incorrect, it results in unemployment. There are no substitutes for your own wage. If the price of apples were double what it should be, people could buy other food instead. Sure, apple farmers and consumers might be unhappy, but people would get by. But when the wages in someone’s industry (or overall economy) are too high, they are pushed into involuntary unemployment, which is devastating. When their wages are too low, their entire standard of living is lower than it should be. Once again, if policymakers could not determine which disequilibria were most costly, it would be better to target spending overall (NGDP).
If prices were perfectly flexible, monetary policy wouldn’t adjust current relative prices, but they would still have a distributional effect due to debt contracts and affect the rate of return for holding currency. Variation in AD only affects the distribution of wealth thru debt payments when it is unexpected. If both borrower and lender expect 10% NGDP growth, interest rates will be 5% higher than if they expect 5% NGDP growth. In real terms, the loan will be the exact same in both cases. In this case, the only requirement for AD management is that it is stable and predictable. Any stable and predictable policy will do. Level targeting is far superior to rate targeting in terms of predictability because central bank errors cancel one another out over time, whereas with rate targeting, errors cause long run NGDP growth to resemble a random walk. If you are making a long term loan, you don’t care if the last year is off by a percent or two, but if the central bank is off by a percent in 25% of the years, you could be talking serious money. Central banks kind of stink at targeting macroeconomic variables in the short run. A level target pushes policymakers to fix their mistakes.
Store of Value
One of the critical functions of money is that it can transfer spending power thru time. Generally, economists (and non-economists!) favor consistent spending power over time for a fixed nominal value of money. Philosophically, this makes a lot of sense. If I provide the market with a certain value of goods and services today, I should get back the same value of goods tomorrow. But not all production periods are created equal. Many goods and services need to be produced close in time to when they are consumed, like sour cream or haircuts. There should be some incentive to consume goods when they are easiest to produce, so prices should rise when the economy is hit by a negative supply shock. Even under inflation targeting this happens to some degree as real wages decline in response to the shock, but under a productivity norm or NGDP target, nominal prices would actually increase in direct response to supply shocks while nominal wages would remain constant. In the long run, most people transfer purchasing power into the future thru real investment, which is not affected by the inflation rate, except indirectly thru taxation. I don’t think the cost of holding currency is high enough to worry about at reasonable levels of inflation.
I hadn’t originally intended this to be a post about how awesome Earl Thompson was, but that seems to be how it’s turned out. If the central bank should deviate from NGDP targeting, it seems like they should move to a target which is stickier and more important to overall market functioning than the average good. Note that gold meets none of those criteria, but a wage index seems like a darn good candidate.