We Need More Inflation Because We Need More AD

Mark Thoma has a new post over at CBSMoneywatch.com where he asks why so many economists are now criticizing Bernanke for failing to raise the Fed’s inflation target.  At one point he challenges economists who do favor higher inflation to come up with a model that would justify this policy.  Thoma doesn’t think that new Keynesian models featuring price stickiness are applicable to the current crisis, which he says is caused by banking problems, not price stickiness.

I think Thoma’s views are probably pretty widespread, but I also think his article perfectly illustrates how the subject of inflation targeting can lead economists astray.  The answer to the question he raises is actually very simple; we need more inflation because we need more AD.  Ah, you might be thinking, but how do you know we need more AD?  My response is that Thoma seems to think we do, at least that’s the implication of statements like this:

I have emphasized a portfolio approach involving both monetary and fiscal policy in the hopes that one or the other will get the job done.

Indeed, unless you are a professor at a major salt water economics department, I would think that it is pretty obvious that the economy could use a bit more aggregate demand.  [edit: I meant freshwater university.]  But what does that have to do with inflation?  Inflation is not a good thing in and of itself; rather it is an inevitable side effect of more AD.  (OK, if the SRAS were completely flat you might not get any additional inflation.  But that would be a situation where more monetary ease would be especially useful, so it’s hardly an argument against a more expansionary Fed.)

I think a lot of people tend to over-think the problem.  They look for all sorts of transmission mechanisms.  More inflation might lower real wage rates, or it might lower real interest rates, or it might boost velocity.  But it is really much simpler than that.  We need more inflation because we need more AD.  In that case you might ask; “why target inflation then; why not target AD directly, if that is what you are trying to increase?”

That would be a great idea!  Does anyone know of a good proxy for total spending on all goods and services in the economy?  If we could find such a proxy, we could simply target the growth rate of that variable, and then forget about inflation.  After all, it is spending we are trying to boost, not inflation.  Any suggestions?

PS.  The government just downgraded NGDP growth in the 3rd quarter from the original estimate of 4.4% to 2.6%.  You may recall all the fiscal stimulus fans crowing about how the 4.4% figure showed stimulus was finally working, even though it was below trend.  Now it seems like fiscal stimulus has failed, so obviously we need even more fiscal stimulus.  I used to argue that every American would need to have their wage cut 8% relative to a trend line from mid-2008 to restore full employment at current levels of NGDP.  I’ve never met anyone who has had that big a wage cut.  With the new NGDP figures even an 8% cut relative to their normal increase wouldn’t get the job done.  One of three things must happen:

1.  The Fed needs to produce much higher NGDP.

2.  Americans need to accept far deeper cuts in their wages.  And not just factory workers, not just unemployment workers, everyone needs a deep pay cut.

3.  We can endure years more of high unemployment, with many lives being ruined.

Something for the Fed to think about.