Scott Sumner wrote a post today called "A NGDP targeting counterfactual". It was a discussion over what would have happened if NGDP targeting was used in the middle of 2008. He says there would have been a boom in asset prices, and that the crisis would not have happened. Then he writes about maybe being wrong.
Well, what would have happened if we had used the monetary policy based on labor share of income? But I am not talking about just in the middle of 2008. The economy was already unraveling at that point. What if labor share policy had been used since the beginning of 2007?
Monetary policy based on labor share is based on the equation...
Prescribed Fed rate = z * (TFUR2+els2) - (1-z) * (TFUR+els) - inflation target
z is a coefficient for an economies equilibrium level... TFUR is the product of labor and capital utilization rates... els is effective labor share (labor share: business sector, 2005=100, * 0.78)
It needs to be noted here that the equation does not target a certain level of labor share. The equation is only based on existing labor share that responds to the natural liquidity of effective demand in the business cycle. I will do a follow-up post on targeting labor share.
In the following graph (using the Effective demand - Aggregate supply model) the inflation rate (blue dots) is plotted with the actual Fed rate (yellow dots) and the Effective demand prescribed Fed rate (red dots).
1st quarter 2007 starts to the left and moves to the right as real GDP increases. The inflation rate stays low until 4th quarter of 2007, when it jumps up as the effective demand limit is reached. Inflation normally jumps at the effective demand limit because the LRAS curve is found there. Anyway, the actual Fed rate was over 5% through 2007 until it started to drop as the recession started in the 4th quarter of 2007.
The Fed rate prescribed by labor share (red dots) was lower than the actual Fed rate throughout 2007 by 2%. Monetary policy would have been much looser before the recession. Yet, when 2008 came, the actual Fed rate and the prescribed rate based on labor share were almost identical for the first two quarters. (see red oval) The Fed rate eventually came into line with labor share policy in the middle of 2008.
Why was the Fed rate based on labor share lower in the first place? Because labor share itself was low for the economy. Effective labor share was around 78% in 2007. Effective labor share needs to be over 80% in order to have a healthy economy.
Scott Sumner says that NGDP targeting would have boosted asset prices and that this would have avoided the crisis. My view is that a lower Fed rate was needed because effective demand was weak from low labor share in the first place. Asset prices were a result of the bubble and didn't need to be raised anymore. The economy was off-balance. Asset prices were too high for the liquidity of labor income. The real solution would have been to find a mechanism to re-balance the liquidity of labor income with asset prices.
And I see the David Beckworth is preparing a paper on the idea of "unexpected declines in expected nominal income growth".
The next step is to develop an equation for a monetary policy that targets a level of labor share of income. See next post.
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