Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Monday, June 4, 2012

NGDP targeting in an OLG model

I'm still trying to work through this NGDP targeting idea. A lot of people graciously replied to my earlier query here, including David Beckworth here (David links up to others who have also contributed their thoughts.)

So much material. So little time. I find myself reading, and then re-reading these replies, trying to absorb the arguments. As I continue to do so, I thought that I'd reciprocate with a gift of my own; something that people strongly in favor of NGDP targeting can mull over and reflect upon. I am going to approach things a little differently here, however. I want to present my argument within the context of a formal economic model, where the assumptions are laid bare. Along the way, I'll try to present the economic intuition as best I can.

Let me consider a simple OLG model. Before I begin I should like to say that if you have something against the OLG model relative to standard macro models, you should read Michael Woodford (1986). Woodford shows that the dynamics of debt-constrained economies can look a lot like OLG dynamics. So I could use the Woodford model in what I am about to say, but I stick to the OLG model because it is simpler and the economic intuition is the same.

An OLG Model

There is a constant population of 2-period-lived overlapping generations (and an initial old generation). All agents care only for consumption when old; in particular, the preferences for a date t agent are Etct+1 (expected future consumption).

The young are endowed with y units of output and they possess an investment technology such that kt units of output invested at date t yields zt+1f(kt) units of output at date t+1. Capital depreciates fully after it is used in production. The future productivity of capital is a random variable. There is another random variable nt that is useful for forecasting future productivity zt+1. Let z(nt) = E[zt+1 | nt] and assume that z(nt) is increasing in nt. I call nt "news", higher realizations of nt "good news," and lower realizations of nt "bad news." Assume that nt is an i.i.d. process.

Note that because there is no growth in this economy, the "natural" real rate of interest is zero.

There is a second asset in this economy in the form of interest-bearing government money/debt (I make no distinction here between money and bonds). Let Rt denote the gross nominal interest rate paid on the outstanding stock of government money/debt Mt-1.

Nominal debt is an important consideration for the arguments in favor of an NGDP target and so, I make the assumption here. In particular, I assume that the nominal burden of the debt RtMt-1 is not indexed to the price-level pt; see also, Champ and Freeman (1990). Because agents differ at a point in time with respect to their wealth portfolios, a surprise change in the price-level will induce unexpected wealth transfers.

The budget constraints for a representative young agent are given by:

when young: ptkt + mt = pty - ptTt
when old: pt+1ct+1 = pt+1zt+1f(kt) + Rt+1mt

So the young "work" to produce output y, pay taxes ptTt,  investment in capital kt, and money mt (from the old). When the young become old, they consume out of the returns from capital and money/bond investments (that is, they consume the returns to their capital and sell their money to the new generation of young for goods and services).

It turns out to be convenient to express things in "real" terms. To this end, define qt = mt/pt (real money balances) and Πt+1 = pt+1/pt (the gross inflation rate). The two equations above may now be combined and expressed as follows:

ct+1 = zt+1f(y - qt  - T) + (Rt+1 / Πt+1)qt

So, conditional on news n, a young person chooses his demand for real money balances q (and implicitly capital investment k) to maximize expected consumption (after-tax wealth, in this case). Since f(.) is increasing and strictly concave, the first-order condition describing money demand is:

z(nt)f ' ( y - q - T) = Rt+1 E[1 /Πt+1 | nt]

The equation above implicitly defines the aggregate demand for investment kt = y - qt. The RHS is the expected real interest rate. An increase in the expected real interest rate reduces investment demand. A good news shock increases investment demand (for any given expected real interest rate). Notice how a news shock looks like an aggregate demand shock (the aggregate demand for output rises with no contemporaneous increase in output). If you want, you can think of  the equation above as defining an IS curve, with y pinned down by exogenous factors (labor market clearing, in a neoclassical model). In short, I think this is all pretty conventional.

I consolidate the monetary and fiscal authority, so that the government budget constraint (GBC) is given by:

ptGt + (Rt - 1)Mt-1 = (Mt - Mt-1) + ptTt

The LHS is the sum of government purchases plus (net) interest on the debt; the RHS is new debt plus net tax revenue. In what follows, I assume G = 0 for all t.

Let Mt = μtMt-1 and rearrange the GBC as follows:

 (Rt -  μt )Mt-1 /pt  = Tt

Notice  here that a surprise increase in the price-level reduces the real burden of the debt.

Finally, impose the market-clearing conditions:

ptM t= qt for all t

which implies:

Πt+1  = μt+1qt/qt+1

Combine this with the FOC above to form:

(*) z(nt)f ' (y - q-Tt ) qt = Rt+1 E[ qt+1  /  μt+1  | nt]

Finally, we have: NGDPt = pt[ y + ztf(kt-1) ]

A Benchmark Policy

Set Rt = μt = 1 for all t, so that Tt = 0 for all t.

Notice that since n is i.i.d., we have E[ qt+1 | nt] = Q (some constant). Consequently, condition (*) may be written as:

z(nt)f ' (y - qt)qt = Q

Proposition 1: q is a decreasing function of nt.

The proof follows from the strict concavity of f(.), the fact that z(.) is increasing in  nt , and that Q is a constant. The intuition is as follows: Good news raises the expected return to capital formation--the demand for capital rises, and the demand for government money/debt falls. This is a strait forward portfolio reallocation effect. If the news is "bad" (a decline in  nt), then the demand for government securities rises -- this looks like a "flight to safety" event.

Consider a bad news event. There is a collapse in investment demand kt, and an increase in the demand for government securities qt. From the market-clearing condition, pt = M / qt. That is, the bad news event causes a surprise drop in the price-level (a sequence of such events would lead to a surprise deflation).

The surprise drop in the price-level leads to a surprise increase in the purchasing power of government securities. In this simple set up, the stock of government securities is held entirely by the old (the high propensity to consume agents) prior to the realization of the news shock. The young (the high propensity to invest agents) wish to acquire these securities as part of their wealth portfolios. The decline in the price level makes the real value of nominal government debt more expensive. In this way, bond holders are able to secure more labor power (y) from the young, so that fewer resources are now available for investment. The decline in capital spending leads to an expected decline in future NGDP (and RGDP). Note: I say expected because the future capital stock is lower; but future GDP may turn out to be higher or lower than expected depending on the realization of the productivity shock z.

Stabilizing the (expected) NGDP

It is possible here for the government to stabilize the expected NGDP path by conditioning the nominal interest rate on news (or, if the lower bound is a constraint, the same effect could be achieved by altering the expected inflation rate via money creation). The key is to stabilize capital spending; and the way to do this is to lower the nominal (hence real) interest rate on government securities. In this way, the decline in the price-level can be avoided. And NGDP remains elevated, despite the bad news, because capital spending is "subsidized" and the price-level remains stabilized.

But is stabilizing the NGDP path a desirable policy?

Well, it depends on what one means by "desirable." If you objective is to stabilize NGDP, then the answer is "yes." In terms of maximizing the expected utility of the representative young agent, however, the answer appears to be "no;" at least, not in this case. (Welfare calculations in heterogeneous agents economies, like this one, can be complicated--as is the case in reality.)

The intuition is this. When the news is bad concerning the future return to investment, it is optimal for investment to contract (and for savings to flow into more stable return vehicles, like government securities). To put it in more colloquial terms: the real rate of return on capital spending sucks (at least, in expectation). In fact, the real return would be less than the population growth rate -- the natural rate of interest in this economy.

Animal Spirits?

Implicit in a lot of discussions about the desirability of stabilization policy is the idea that the business cycle is inefficient. One way in which they may be inefficient is if expectations are prone to fluctuate purely for "psychological" (exogenous) reasons. In the context of the model developed above, we might instead assume that "news events" are instead just "animal spirits" that move expectations around for no particular reason. Assuming that policymakers are somehow immune to such effects, it would indeed be desirable to stabilize NGDP in this model.

Is this what proponents of NGDP targeting have in mind?  I have no idea as they rarely, if ever, are explicit about what they assume are the driving forces of the business cycle. All I mostly ever hear is a "negative AD shock," whatever that is supposed to be. (The two examples above, rational pessimism and irrational pessimism, both lead to a reduction in AD in some sense, for example.)

An Alternative Policy

Let me modify policy in a minor way; i.e., Rt = R > μt = μ = 1.

From the GBC above,  (Rt -  μt )Mt-1 /pt  = Tt, so that under this policy, the young are required to finance the carrying cost of the public debt.

It is easy to see that if the young must allocate more resources to service the debt, less resources will be available for capital spending. And a surprise decrease in the price-level now has two effects. First, there is the effect described above. Second, the real tax burden on the young must rise, if the government's nominal obligations are to be met.

Although I haven't fully worked it out, it seems to me that this second force constitutes a drag on capital spending that should be avoided, if possible. In particular, a better policy would apply the tax Tto the old, instead of the young.

So in this case, it seems that some policy designed to support the price-level (hence NGDP) might be desirable. Although, once again, if the information that leads agents to reduce capital expenditure is the best information available, then one would not want to stabilize NGDP perfectly.


The model presented above is highly abstract. Nevertheless, I think that it captures some forces that may presently be at work in real world economies. Pessimistic expectations over the future return to investment (whether via a productivity slowdown, as documented here, or through the rational--or irrational--expectation of a higher tax rate on investments) will act as a drag on the economy, and make competing savings vehicles, like US treasuries, relatively more attractive. The effect is deflationary and, to the extent that nominal debt is not indexed, there will be redistributive consequences.

Even though the model delivers a plausible interpretation of some recent macroeconomic developments, a NGDP target is not an obvious solution. But of course, as I said, the model is highly abstract. It is likely missing some features of the real world that NGDP target proponents think are important. If this is the case, then I'd like to hear what they are, and how these elements might be embedded in the model above. If nothing else, it would be a contribution to the debate if we could just get straight what assumptions we are making when stating strong propositions concerning the desirability of this or that policy.


There are still a lot of theoretical issues to resolve concerning the relative merits of different monetary policy rules, especially in the context of an open economy. One such paper that explores this question is: "What to Stabilize in the Open Economy" by Bencivenga, Huybens, and Smith (IER 2002). Among other things, the authors find a price-level target gives rise to an indeterminancy, and endogenous volatility driven by expectations.

Postscript June 15, 2012: Josh Hendrickson offers an extended comment here. Thanks to Josh for this; I will reply soon.


  1. This week David says there is "a productivity slowdown, as documented here."

    Last week he denied such.

    Nice when you just make it up as you go along.

    Bencivenga, Huybens, and Smith . . . find a price-level target gives rise to an indeterminancy, and endogenous volatility driven by expectations.

    They must have read their Soros.

    1. You're not fooling anyone, John D, and apparently you can't figure out how to read dates on papers. You're truly dumber than a box of hammers.

  2. still digesting. Looks to me that consumers are risk neutral (preferences are expected future consumption). It's not clear that think changes the result, but intuitively i would expect it to make a difference.

    1. DWB,

      Yes, consumers are risk-neutral. Does this matter for the result? I do not think so.

      Making consumers risk-averse will have the effect of increasing the level demand for real government debt; it is now useful as insurance.

      But if information signals low future returns to capital spending, even a social planner would want to economize on investment spending. This qualitative property of the model is independent of risk attitude.

  3. When output is given and prices are perfectly flexible, nominal GDP targeting will have few benefits. So, you should always be sure to make explicit your assumptions along those lines.

    Anyway, supposedly young people expect their capital goods to be less productive when they are old, so they prefer to produce fewer of them and instead produce consumer goods for the old people and accumulate money/bonds.

    The quantity of money is given, apparently, so this creates deflation. The old people get extra consumer goods, and the young people get less money per consumer good, with the prices they receive being lower.

    Then next period, they will be able to spend it on consumer goods produced by the next generation. It seems to me that this money for which they gave up more consumer goods will buy them less consumer goods once the next generations willingness to supply consumer goods returns to normal.

    But then, I guess the real return on capital is supposed to be negative too. (I don't think the natural interest rate is the interest rate without the realization of the productivity shock, but if the no shock one is zero, then I guess a negative shock makes it negative absolutely.) And so we are equalizing that negative return on capital with a negative across generation transfer.

    From a market monetarist perspective, the quantity of money should rise. The young people want to hold more money, and so more should be issued, presumably in exchange for consumer goods. Obviously, the old people have to get the consumer goods since no young person wants them. But the government is creating the money.

    OK, the government pays extra "interest" to the old people today, expanding the quantity of money. And gets it back by paying less interest to the current young people when they are old.

    The old people buy more consumer goods, the young people get more money, but earn lower interest on the money/bonds.

    I guess I just don't understand. Because it seems to me that when the current young generation expects a poor return from capital goods and they switch to selling more consumer goods so they get a lower return from money too, driving down money prices, until the expected inflation rate makes the real interest rate equal to the lower expected return on capital goods, it is just creating a windfall for the current old folks.

    It seems to me that to provide more to the current group of young people, taxes must be increased on the next group of young people, making up for the unusually low productivity of capital this period.

    And I don't see what this could possibly have to do with nominal GDP targeting.

    Also, in this scenario, output is constant, and so constant nominal GDP is the same a constant price level. But the debate is which of those is better.

    Fixed quantity of money, higher money demand, and deflation somehow being better because it prevents too much investment is beside the point.

    So, I suppose clarification for me would require explaining how the next generation of young people are motivated to produce extra consumer goods for the current generation of young people.

    (In my constant price level/nominal GDP scenario would could do it by "paying" for the higher interest paid to current old people with higher taxes on the next generation of young people. But I don't see how allowing deflation now does the trick.)

    1. Bill,

      Also, in this scenario, output is constant, and so constant nominal GDP is the same a constant price level.

      No, output is NOT constant in this model; it fluctuates with the productivity shock and with different levels of investment spending. Even if the productivity shock is held constant, the news shock will cause variation in capital spending, and this will cause variation in the future level of RGDP. So, output is not constant in this model (except in the impact period of the news shock -- but this simplification is easily modified).

      As for price flexibility, yes, prices are flexible. In fact, flexible prices here are critical for generating the requisite wealth transfers from debtors to creditors when the nominal terms of debt contracts are fixed. I thought this channel (Fisher's debt-deflation story) was a big deal for proponents of NGDP and PL targeting types.

    2. "I thought this channel (Fisher's debt-deflation story) was a big deal for proponents of NGDP and PL targeting types."

      well, sort of. my observation is that there are actually several "camps" of ngdp targeters. I am not sure its a unified body.

      First there are those who like it because it a close cousin of the Friedman 3% rule, except we know velocity is not stable so you can only look at nominal income. Interest rates are a very poor indicator of monetary policy and you cannot judge the output gap from inflation. Hence this line of thinking suggests that we *only* know whether policy is accomodative or tight from ngdp growth.

      Second, there is the "dont respond to supply shocks or import price shocks" or "ignore relative price changes in the CPI" argument. I think this camp would also be ok with GDP deflator path level targeting.

      Third, there is the sticky price/wage camp, here you have "optimal control" NK models (DeLong, Woodford, etc) where the central bank problem is something like p + k y where k is the degree of price/wage stickiness. When k is 1 this is ngdp growth targeting, which leads me to:

      fourth, there is empirical evidence (i.e. VAR-based statistical models, ie Orphanides and McCallum) that suggests that NGDP targeting outperforms IT, which is evidence for three. Marcus Nunes has some excellent graphs on this. The Orphanides paper suggests NGDP growth targeting performs better under uncertainty (when we dont know the true output gap).

      fifth, debt deflation is an important source of nominal stickiness.

      in NK and other models, many people would argue its "nominal" expectations that count with regard to 1-5, but i guess that sort of is implied by the nominal stickiness.

      If that does not sound like an organized story to you, and you are out of breath, then yes i would agree. just my opinion.

      But I would not say debt-deflation is the "biggest deal." for example, I would venture to guess Sumner thinks about it in something like a Woodford NK model, plus #1-2. I( almost want to say every proponent would have a different point of emphasis (x3, we all know that joke).

      I totally agree that i think its important to understand under what conditions ngdp targeting is good (not every recession will be like the last one, hopefully).

    3. oh there are also the dual-mandate-ists who are weakly supporting but just want the Fed to focus on the other half of the mandate. I would put PK in that camp.

    4. DWB, can you send me a reference relating to the VAR literature you cite above? Thx.

    5. I suspect you may already have seen these but that i butchered the description as I was using that term somewhat loosely (there is overlap between 3 and 4 clearly), to describe loosely some linearized structural models in the Taylor Rule/ FIT thread calibrated to empirical data which have something like a variance objective function and asks "what rule performs better" empirically given various weights on output/inflation loss. Still, here are some links.

      "The Quest for Prosperity Without Inflation" Orphanides

      "Nominal Income Targeting in an Open-Economy Optimizing Model" McCallum, Nelson

      "Policy Rules for Inflation Targeting" NBER # 6512 Rudebusch, Svensson


    6. i came across this one also. i am including it because its illustrative of the supply shocks point i made above (there is a Bernanke Gertler paper that makes this point better), but mainly because of the following paragraph:

      “The ECB announced a reference value for M3 growth of 4.5% calculated as the sum of an inflation target and a foretasted trend growth rate of real output of 2.5%”

      It serves as a useful reminder that many central banks back in the day (the day being 2003) including the Fed and ECB gave very strong credence to the monetarist perspective.

  4. This model is exactly why the NGDP conversation was so frustrating. It came off as if the debt-deflation issue was a big deal for nominalists and in fact it is peripheral. Sticky prices are critical, but nobody wants to talk about sticky prices because there is not much smart to say on either side because the models and evidence so far are not exactly overwhelming in either direction. Wondering why NGDP targeting wouldn't help in a world with flexible prices like this model means that these guys haven't done a good job prioritizing the things they think make a stable upward nominal path important. Though there are people who might have interesting things to say about the benefits of NGDP targeting in a flexible price model like this (Roger Farmer, for example), I think this sidesteps the annoying fact that sticky prices are very important to most others.

    I understand how production declines in this model but what causes large spikes in unemployment?

  5. DLR,

    I am a little puzzled by your remarks. First of all, I do have a "sticky price" in the model (the nominal interest is a price). I'm not sure how much it matters where we stick this rigidity; the point is that price-level changes will alter real variables, if the nominal price is sticky.

    Second, I have shown above how NGDP targeting CAN help; in particular, by taking a particular stand on the source of the underlying shocks (in this case, fundamental vs. psychological).

    Third, there is no unemployment in my model, but I could have added it easily along the lines of Mortensen and Pissarides. Bad news would lower the return to recruiting activities, making it more difficult for workers to find jobs, increasing the unemployment rate. No price rigidity is needed for this result.

  6. btw this is very good:

    I have not read the book but having been on both ends of the process (i just just interviewed a candidate for an open position), i agree with almost everything he says. The only thing i would add is that a lot pre-screening is done by HR (which have no idea about what the job entails) *by policy*. They have no idea, and the net result is a resume full of random buzzwords. YUes, hiring managers put their "wishlist" on the job description, but with rigid HR policies one is forced to take either a completely generic nondescript approach or a shotgun approach (include everything!).

    My cynical worldview is that a lot of this is driven by incentives. Companies pay headhunters, which often are a lot more knowledgeable and maintain contacts at HR. no surprise, certain HR departments work more closely with certain headhunters. Good HR reps disappear to headhunter firms. I can't tell you how many times friends of mine have been contacted by headhunters whose main skillset was knowing how to "game" the internal HR system (which varies widely by company) and frankly did nothing more than put the resume into the corporate system.

    next time you see a so-called talent survey keep in mind that when demand for labor is higher, hiring managers become less picky and more willing to "train"

  7. Alligator Boats

    Why do economists cling to a failed theories and persist in thinking and writing about Government Alligator Boats?

    Mark Twain, Chapter 24, Life on the Mississippi

    Once, when an odd-looking craft, with a vast coal-scuttle slanting
    aloft on the end of a beam, was steaming by in the distance,
    he indifferently drew attention to it, as one might to an object
    grown wearisome through familiarity, and observed that it was
    an 'alligator boat.'

    'An alligator boat? What's it for?'

    'To dredge out alligators with.'

    'Are they so thick as to be troublesome?'

    'Well, not now, because the Government keeps them down.
    But they used to be. Not everywhere; but in favorite places,
    here and there, where the river is wide and shoal-like Plum Point,
    and Stack Island, and so on--places they call alligator beds.'

    'Did they actually impede navigation?'

    'Years ago, yes, in very low water; there was hardly a trip, then, that we didn't get aground on alligators.'

    It seemed to me that I should certainly have to get out my tomahawk.
    However, I restrained myself and said--

    'It must have been dreadful.'

    'Yes, it was one of the main difficulties about piloting.
    It was so hard to tell anything about the water; the damned
    things shift around so--never lie still five minutes at a time.
    You can tell a wind-reef, straight off, by the look of it;
    you can tell a break; you can tell a sand-reef--that's all easy;
    but an alligator reef doesn't show up, worth anything.
    Nine times in ten you can't tell where the water is;
    and when you do see where it is, like as not it ain't there
    when YOU get there, the devils have swapped around so, meantime.
    Of course there were some few pilots that could judge of
    alligator water nearly as well as they could of any other kind,
    but they had to have natural talent for it; it wasn't a thing
    a body could learn, you had to be born with it. Let me see:
    there was Ben Thornburg, and Beck Jolly, and Squire Bell,
    and Horace Bixby, and Major Downing, and John Stevenson,
    and Billy Gordon, and Jim Brady, and George Ealer,
    and Billy Youngblood--all A 1 alligator pilots. THEY could tell
    alligator water as far as another Christian could tell whiskey.
    Read it?--Ah, COULDN'T they, though! I only wish I had as many
    dollars as they could read alligator water a mile and a half off.
    Yes, and it paid them to do it, too. A good alligator pilot could
    always get fifteen hundred dollars a month. Nights, other people
    had to lay up for alligators, but those fellows never laid
    up for alligators; they never laid up for anything but fog.
    They could SMELL the best alligator water it was said;
    I don't know whether it was so or not, and I think a body's got
    his hands full enough if he sticks to just what he knows himself,
    without going around backing up other people's say-so's,
    though there's a plenty that ain't backward about doing it,
    as long as they can roust out something wonderful to tell.
    Which is not the style of Robert Styles, by as much as
    three fathom--maybe quarter-LESS.'

    NGDP targeting, the Taylor Rule, Ricardian Equivalence, the list is endless. Everyone one, in its own way, is nothing but an Alligator Boat.

    1. If that wasn't written by Mark Twain I would have told you that I was dumber for having read it.

      If you knew as much about economics as you think you did, you would be writing papers explaining alternatives to these theories rather than simply quoting Mark Twain in the comment section of a blog post.

    2. First, I am very confident that I know more about economics than you, or anyone else writing or reading here, as shown by the mere fact that I knew (but you did not and no one else here did either) that Mark Twain saw through modern macro economics before there was even a modern macro economics.

      It was written by Mark Twain and you would have been a lot smarter had you read such and understood and applied such, instead of all the silly macro "papers" you have read.

      The metaphor of Alligator Boats is wonderful. And, I didn't include his comments on expectations---did you read those---the alligators now all run into the woods when they hear the Alligator Boat coming.

      You know a great deal about nothing, but I know a little about most everything. That gives me the altitude and perspective to see that macro economics is a failed science. You are down in the forest and wholly lack altitude and perspective. But don't take my word for it, read Martin Wolf this week or Soros and Munger, all the time.

      I post here mostly for one reason only: to see the cognitive dissonance in action. It is a real time experiment. I am looking for some way to talk to people who are, like you, in denial and you have it bad (I am not a Phd. who has claimed to have spent a lifetime getting the answer right about macro, so I have no responsibility to offer papers, etc. to save a failed science---and no one would publish them anyway). Very few have the ability to admit they are wrong.

      Had I posted the Alligator Boat story, as you say, you wouldn't have read it. But, Mark Twain, that changes the entire equation. Here is a man who in a few simple paragraphs has told a story that cuts through to the heart of macro and exposes it fundamental failures.

      I have commented here on my theories, but they mostly nothing to do with models. You seen, in addition to having some education about economics I also have some education about politics, history, art, and literature and, in my view, history trumps economics right now; history has far more to teach us.

      Europe, right now, needs a Hamilton or perhaps several Hamiltons, badly. Europe needs lessons in history about how to correctly form a fiscal union. Europe needs to see the parallels with the formation of the United States (and the pitfalls to be avoided).

      I could go on, but there is no point. You and others will only exhibit more hatred of me, for being right about what you have spent a lifetime being so wrong.

      Even David hates me, even though I believe he is fundamentally right in his insights, when he writes of coordination, trust, etc., (but he refuses to act or lead, based on them, so what am I to do when he wanders off.

      In sum, there will be no papers because there is no theory, or in Munger's words, lattice on which to hang the paper. Macro economics is irrational. If the irrationality can be managed, it will take a much more effective political system than we presently have, as Wolf lamented this week.

    3. "You know a great deal about nothing, but I know a little about most everything."

      I don't know who I am or what I know. Also, I would prefer that you knew a lot about something rather than a little about anything.

      "That gives me the altitude and perspective to see that macro economics is a failed science. You are down in the forest and wholly lack altitude and perspective. But don't take my word for it, read Martin Wolf this week or Soros and Munger, all the time."

      This is the logical fallacy of an appeal to authority...and a weak one at that. I wish you knew more about logic.

      "I am not a Phd. who has claimed to have spent a lifetime getting the answer right about macro, so I have no responsibility to offer papers, etc. to save a failed science---and no one would publish them anyway."

      You claim to have answers, but nobody would publish your papers? Why not? Because the entire world is inherently biased against the right answers?

      "Had I posted the Alligator Boat story, as you say, you wouldn't have read it. But, Mark Twain, that changes the entire equation."

      For literary value...

    4. Economics is nothing but an appeal to authority. Citation to a book or paper or speech is an appeal to authority.

      Wolf, Soros, and Munger give their reasons; there is no need for me to repeat them. Wolf's column is especially to the point. Only a failed science would produce what has happened. We are having a repeat of the arguments made in the 1930s, which conclusively shows a science that has learned nothing (and therefore isn't a science).

      Macro is entirely against right answers. Look at all the papers published that are wrong. Look at the presidential speech by Lucas which was totally wrong. Look at everything that is false, like Barro's RE, that get's published and repeated.

      Show me all the papers and models that predicted the current Depression? Show me any model that has been corrected, since 2007, that will get the result correct the next time?

      Or, my favorite, show me a model that will accurately predict the value of a mortgage on US real estate in 20 years?

      Of course, the point is that financial markets are irrational, as they are based on imperfect information in which imperfect people operate. As markets become larger and more people are involved they will become more irrational.

      There is no need to publish a paper to show this irrationality. One only need look at a single chart, federal debt to GDP. If one does such you will see that we reached our lowest post WWII ratio under the Presidency of Jimmy Carter, at about 39%. If the level of Fed. Debt mattered, we should have been in the best of times, but we were instead in about the worst of times. Why? Because of a torrent of psychological blows (Vietman, Nixon, Oil Embargo, Pardon, etc.)---that old Vision thing.

      The only counterbalance is a government which has extraordinarily broad powers managed by people whose incentives are carefully set and monitored (Munger), who will attempt to manage expectations, knowing that the Alligators will run to the forest when they hear the Government boat coming.

      Now, I am not describing technocrats. I am describing the leadership of the Country. We are running on 12 years now of totally failed leadership, leadership that has failed for many many reasons (many of which are very complex having to do with fundamental shortcomings in the Constitution and our form of government).

      There was a great book, written last year, Suskind's Confidence Men. The title of the book and concluding discussion on the role of government is the beginning and end of macro: confidence.

      It is pitiful to state that Richard Nixon understood this more than the writer and readers here. The SOB had the good sense to wear a dark suit, white shirt, appropriate tie, and polished black shoes when he went to the beach because he was The President.

      In the shadow of this failed leadership, modern macro has been a great game, played by a bunch of smart people who have made a fortune for themselves by being experts on

      David works with 50 +/- economists at the St. Louis Fed. 50 x 4 years = 200 man years to come up with science, but they have nothing and will never produce anything.

      Barro says in the WSJ we need to get rid of the Government and cut taxes, that unemployed people are the ones responsible for their own fate and that they need to be hit with a cow prod and shocked into working.

      If Barro were telling the truth, he would have said we should start at the Fed. Res. Banks.

      If modern macro is a science, then every should join me in saying that David and every economists at the St. Louis Fed have two weeks to come up wit the answers or be fired, so we have cut everyone's taxes.

    5. John D, we know who you are, and if anyone bothers to check they'll see your knowledge of economics is essentially zero. Go away.

  8. If I were going to write a paper about why our locomotive is stalled on the track it likely would be about the lack of pressure on the M-4 gauge.

    Further, it might be about how the maintenance of these markets was left up to investment bankers who wholly failed their customers.

    Expectations matter. When you just cheat people to the core they are not going to buy your crap again.

    Would you buy commercial paper from GE,especially if it was offered through a bank that lead the Facebook IPO? Fine, and while your there, buy my share also.

    Add to that, how dishonest business is and one would have the answers.

    The paper on the dishonestly and irrationality that surrounds us has already been written by Michael C. Jensen.

    Jensen, Michael C., Murphy, Kevin J. and Wruck, Eric G., 'Remuneration: Where We've Been, How We Got to Here, What are the Problems, and How to Fix Them,' Harvard NOM Research Paper No. 04-28 (July 2004) and ECGI-Finance Working Paper No. 44/2004.

    Here is the SSRN link

    the chart on page 95 has all the answers to our current situation

  9. The "John D/Anonymous" 10 Commandments for writing comments:

    1. Mention a Lucas speech/paper. State that the speech is obviously idiotic, but provide no commentary. Under no circumstances should you directly address anything Lucas wrote or said. If truly pressed for time, take some comment out of context.

    2. Criticize modern macro. However, be careful not to provide any actual substantive criticism. Keep your comments short and vague.

    3. Quote somebody who everyone is likely to know something about, but make sure that they are dead and that they have little to add to the present discussion. Alexander Hamilton is an example. Mark Twain is another. For example, alligator boats have nothing to with this post and the analogy is really stretched. Fear not.

    4. Make wide-sweeping claims, but be careful not to support those claims with any evidence or argument. It is best to simply state your claim (nay, fact) and move on.

    5. If you happen to read anything written by an economist and wish to comment on it, there are several guidelines to follow: (a) if that economist is Lucas, see point (1); (b) if the economist is not Lucas, offer the most exaggerated and ill-informed summary of the argument and explain why that caricature is irrelevant.

    6. Under no circumstances should you ever suggest that your arguments are subject to debate. You should never write down your ideas in a systematic fashion. Under NO CIRCUMSTANCES should your arguments be reviewed by others. Your arguments are true -- perhaps by definition.

    7. The following phrases must be sprinkled in:

    "Modern macro is garbage."

    "Macroeconomics is not a science."

    "Macro is all about..." Finish this sentence however you like, but never use the same ending. It keeps your readers guessing.

    8. When no other argument presents itself, consult a four year old. For example, when someone says that your argument is an appeal to authority, write a response like, "YOUR argument is an appeal to authority." That will set them straight. Idiot economists.

    9. Reason from simple correlations. Causation be damned!!

    10. Take cheap shots at David. After a certain point he won't respond. Don't worry that his lack of response is due to the fact that he quit reading. His silence is indicative of the fact that you are correct and that he is slowly realizing that modern macro isn't a science.

  10. What happened to the 10commandments of John d? Are you deleting comments?

  11. I do not delete comments, anonymous. My spam filter sometimes withholds comments automatically, until I release them.

    Btw, thanks for your spirited defense, but really, I do not think the fellow is worth the time.

    In fact, I was hoping that this post would lead to a serious discussion. But after a promising start, the comment section quickly degenerated into...well, I'm not even sure I have the words to express my disappointment.

    1. I am not even sure I have the words to express my disappointment that this blog talks about me, rather than the news:

      Fed reports U.S. families lost 39% of worth in recession

      Lucas said in his speech on becoming President of the AEA that economists had the answers to Depressions. He lied. See the news, above. Even a dog knows the difference between being tripped over and being kicked.

      Science = the ability to predict, accurately. Your models cannot predict the future, accurately. Therefore, you are not science; at best, your are failed science and in actuality they are nothing but personal bias.

      I am no more general in my remarks than the blogs of Taylor, Cochrane,Mankiw,Cowen etc., whom none. of your attack for being general or vague. If acceptable by them ...

      The subject above is not one that "would lead to a serious discussion," for it is based on a flawed premise that markets are rational and efficient.

      People will change their actions in response to such a "rule," as Soros and Munger constantly remind.

      I am not going to post anymore, for I have no desire to intrude on people having a pity party. I am right; it is behavior and people that matter, not models.

      I would suggest that David read this story:

      The Dunning-Kruger Effect: Why The Incompetent Don’t Know They’re Incompetent.

      It ends:

      As Socrates once said:

      "The only true wisdom is to know that you know nothing."

      But even this can go too far. It turns out that people with real talent tend to underestimate just how good they are. The root of this bias is that clever people tend to assume other people find things as easy as they do, when actually this is their talent shining through.

      I believe he has talent, but he keeps insisting on wasting such. Since, I believe that talent, not math models matters, I keep pushing him to try to deploy his talent, be he refuses. So be it.

      As for the rest of the "profession," you are incompetent, mostly for the reasons stated in Munger's great speech:

      The Psychology of Human Misjudgment

      8. Nine [he means eight]: what made these economists love the efficient market theory is the math was so elegant.
      And after all, math was what they'd learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they'd forgotten the great economists Keynes, whom I think said,

      "Better to be roughly right than precisely wrong."

    2. John D should be arrested for crimes against silicon. Just think of all the things that could have been made instead of giving him a computer to spew nonsense onto the interwebs.

    3. "Why The Incompetent Don’t Know They’re Incompetent"

      Ah, the irony here is delicious.

    4. It get's better.

      The Noble Prize for Economics was awarded today to the political scientist.

    5. well, i for one am looking forward to round 2.0.

      "John D should be arrested for crimes against silicon"

      nah, its always good to have a reminder about how far we need to go to communicate and educate people. arguments should be won on the merits. It is kinda frustrating though that some people seem impervious to facts.

  12. Restoring the seriousness, Josh Hendrickson responds to David:

    1. Notice John D tried to show up there too. He really is a persistent crackpot.

  13. In response to your comment: "Is this what proponents of NGDP targeting have in mind? I have no idea as they rarely, if ever, are explicit about what they assume are the driving forces of the business cycle. All I mostly ever hear is a "negative AD shock," whatever that is supposed to be."

    I guess this is an example of the freshwater/saltwater divide. When saltwater economists talk about negative demand shocks, other saltwater economists all know exactly what kinds of shocks they have in mind--generally the shocks are just drops in the household's discount factor (so that they value current consumption less), and the model is one with nominal rigidities.

    Often the capital market is ignored for simplicitly, in which case all of the drop in output due to the shock is welfare-reducing, since the shock to preferences does not change the efficient level of output in any way. With perfectly flexible prices, we would have no trouble achieving this level of output in the face of the negative demand shock, but firms cannot profitably adjust their prices right away, we end up with prices too high for the markets to clear. That is, at the prevailing price level, consumers won't buy all of the goods that can be efficiently produced.

    Adding in capital changes things a little, but the basic idea is the same--prices cannot respond perfectly to negative shock to household preferences, so the economy does not produce as much as it otherwise would.

    So to sum up, "negative aggregate demand shock" means exactly what it sounds like--people don't value current consumption as much as they normally would. The critical assumption that we often assume people are aware of but don't always say is that prices are sticky in some way.

    1. Econ -- thanks for this.

      I am, of course, aware of the models that shock the discount factor and then rely on sticky nominal product or factor prices to do the work. And I agree that these shocks "look like" AD shocks in some sense. (Whether we believe the economy to be subject to large coordinated shifts in individual pure discount rates is another matter of course -- but these shocks seem to be standing in for something deeper.)

      Note that the "bad news" shock I describe above can also be interpreted as a negative AD shock. I presume the same might be said of other types of shocks. Does the source of the shock matter for designing policies to cope with AD "shortfall"?

      And finally, note that for economists like Scott Sumner, AD is equated to NGDP. I don't that his notion of AD shock maps very cleanly into yours (as described in your concluding paragraph).

  14. With respect to the recent recession, Scott has suggested that the Fed's policy itself (in early 2008?) was the negative demand shock that started the mess. I believe his story goes something like:
    1) Financial Crisis -> economy still okay
    2) Fed's attention is solely on Financial Crisis, responds to increasing (commodity?) prices by tightening
    3) Fed continues to not notice low NGDP expectations
    4) Fed signals tight policy (relative to demand) in fall of 2008 by keeping rates high and introducing high interest on reserves, market rationally infers that Fed has lost its marbles and won't accomodate demand for money, revises NGDP expectations ever lower, economy starts to tank, Fed continues to focus on financial crisis while Scott's favourite indicators are all flashing red, kaboom
    5) And then Fed continues to drag its feet for a while, and keeps injecting money while signalling that all injections are temporary
    I think that about covers it...
    One relevant post is here:

  15. David,
    hopefully you have seen this:

    there is a link to another paper in this post (which itself has about 80 references). just thought i would pass it on in case you didn t see it.

    actually, ironically, i see that 5 or so are to Ben Bernanke papers. heh.

  16. For the love of peteJune 25, 2012 at 4:10 PM

    Is there a paper that provides a specific mathematical model a la Woodford Interest & Prices-type analysis?

    I have a hard time following without that. This is the closest I've ever found.

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