The Nominal Income Gap: Tenets of Realist Monetarism #2
Or, overheating and recession are two sides of the same coin
This is my first post in a while, as I was busy with schoolwork. From now on, I am gonna post more often, and with more effortposts made.
Today, I want to present the way I think about the nominal economy in more formal terms. I wrote briefly on this in an old post of mine:
1) The Monetarist view of recessions focuses quite simply on disequilibrium between expected nominal spending and actual nominal spending. When there is a gap, whether it be an NGDP gap or a cash-balance interpretation (a la Yeager), it is because there wasn’t enough money (an allocative substance) to go around and hold the economy, the price system, together. Remember that here it is not the total quantity that truly matters but the flow and expectations. This applies for all my points.
2) Closely related to (1) is that the Monetarist view of inflation is that long-run inflation is driven by the inverse of the drivers of recession: when there’s too much money to go around, prices rise. Inflation and recession are two sides of the monetary equilibrium coin. This relates closely to Friedman’s Plucking Model: the economy can never go past its potential output, so any additional nominal spending over potential will be solely inflation. An economy can never run too hot, only the monetary authority can run too hot.
Basically, my idea is that the difference between potential and expected nominal expenditure drives the dynamics of the macroeconomy. There are a couple assumptions this relies on. One is that there is sticky factors (such as contracts) that rely upon the path of nominal income in the economy. Two is that the economy is relatively stable given its level of nominal income is maintained.
What this means is that a constant amount of nominal income yields a dynamic and efficient economy, while fluctuations in that flow cause epidemics of market failures. This model skips breaking down nominal income, as Friedman did in his 1971 paper1 I consider one of his finest.
A Brief Model
Relating expected expenditure with potential output
I’ll start by defining the the two terms that I believe determine the most about the output and price level path of the economy.
Future potential output is current potential multiplied by the potential nominal growth rate:
Expected expenditure is a function of current output and expected nominal growth rate:
The relation between these two variables determines what will happen to the macroeconomy. If expected expenditure exceeds potential output, expect overheating. If the opposite happens, recession and deflation will assuredly happen. Ω is equal to the difference between potential output and expected expenditure:
The future inflation rate and the future real output gap is the function of Ω and markup potential:
The future real output gap is the function of Ω and future inflation:
Long-term behaviour
This model accounts for long-term changes of essential variables, which is important for understand why demand-side policy is so important over the long term.
The current nominal growth rate is a function of the current real output gap and stabilization policy:
Essentially, the real output gap will cause hysteresis in expected nominal expenditures over time. Note that I believe G* to be relatively constant, as institutions, capital stock, and market structures are quite resilient.
Additionally, I expect that the Wicksellian rate to play a part in this equation, specifically within the h() function. The output gap will drive it, influencing the stance stabilization policy will need to adapt to make effective2.
Additionally, stagflation is possible. If µ is high, we can see inflation and a large output gap in tandem. This can factor the role of expectations Friedman discussed in his Nobel Lecture.3
The role of policy
Policy plays a key role in restoring the economy from shocks in my system. One, it can directly address the output gap. Two, stabilization policy can provide the essential service of bringing expected nominal income to the preferred level.
I will agree with the notion that Lucas was wrong about stabilization policy. Economies aren’t perfect under income stress. “The economy needs spending for income,” Skanda Amarnath sometimes says to me, but on a reassuring note, finishes, “but doesn’t always need income for spending.”
Plucking Away
People know I am a massive fan of the Plucking Model of Friedman4. I constructed this framework with it in mind. So, how does Nakamura et al.’s finding that a slightly higher inflation rate is preferable in a plucking environment5 fit in?
I believe my framework would contain functions allowing for inflation to be slightly positive at unity between expectations and potential. Part of the efficacy depends on labour market structure, after all.
Furthermore Onwards
Soon I will conduct a test for this framework, similar to that of Lucas6 and his test of the Quantity Theory of Money. Additionally, I will be working on a continuous and predictive form of this framework, with my choices for functions.
P. S. Thanks to Trevor Chow for helping me with thinking through this. He’s one of the best young econ people, and you should all check him out!
Friedman, Milton. "A Monetary Theory of Nominal Income." Journal of Political Economy 79, no. 2 (1971): 323-37. Accessed May 26, 2021. http://www.jstor.org/stable/1832113.
Sumner, Scott. “A Critique of Interest Rate–Oriented Monetary Economics.” Mercatus Working Papers, November 2020. https://www.mercatus.org/system/files/sumner-critique-interest-rate-mercatus-working-paper-v1.pdf.
Friedman, Milton. “Nobel Lecture: Inflation and Unemployment.” In Milton Friedman On Economics, 1–22. The University of Chicago Press, 2007.
Friedman, Milton. “The “Plucking Model” of Business Fluctuations Revisited”. Economic Inquiry, no. 31 (1993), 171-177. https://doi.org/10.1111/j.1465-7295.1993.tb00874.x.
Dupraz, Stéphane, Emi Nakamura, and Jón Steinsson. "A Plucking Model of Business Cycles." NBER Working Papers, no. 26351 (December 2019). https://doi.org/doi:10.3386/w26351.
Lucas Jr, Robert E. “Two Illustrations of the Quantity Theory of Money.” The American Economic Review 70, no. 5 (1980): 1005–1014. issn: 00028282. http://www.jstor.org/stable/1805778.
Total b.s. Friedman was one dimensionally confused, not know a credit from a debit. Banks are black holes. Banks don't loan out deposits. Deposits are the result of lending. So 15 trillion dollars in bank-held savings are inert.