Friedman’s thermostat and why he obviously would support a NGDP target
In a recent comment Dan Alpert argues that Milton Friedman would be against NGDP targeting. I have the exact opposite view and I am increasingly convinced that Milton Friedman would be a strong supporter of NGDP targeting. Ed Dolan as the same view as I have (I have stolen this from Scott Sumner): “I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s…If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.” Dolan’s clear argument reminded me of Friedman’s paper from 2003 “The Fed's Thermostat”. Here is Friedman: “To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output…since the mid '80s, it (the Fed) has managed to control the money supply in such a way as to offset changes not only in output but also in velocity…The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply -- a veritable bubble in velocity. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.…The relatively low and stable inflation for this period …means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.” Hence, Friedman clearly acknowledges that when velocity is unstable the central bank should “offset” the changes in velocity. This is exactly the Market Monetarist view – as so clearly stated by Ed Dolan above. So why did Friedman man not come out and support NGDP targeting? To my knowledge he never spoke out against NGDP targeting. To be frank I think he never thought of the righthand side of the equation of exchange - he was focused on the the instruments rather than on outcome in policy formulation. I am sure had he been asked today he would clearly had supported NGDP targeting. The only difference I possibly could see between what Friedman would advocate and what Market Monetarists are arguing today is whether to target NGDP growth or a path for the NGDP level. ---- PS I am not the first Market Monetarist to write about Friedman's Thermostat – both Nick Rowe and David Beckworth have blogged about it before.