This view flies in the face of accepted wisdom. Such efforts to reduce demand in 2007–08 were not only unnecessary but were also responsible for the recession and financial crisis. This was thanks to monetary policy, not A good example of the power of monetary policy came in early 2013. Had the Fed targeted NGDP, it might have acted much sooner to boost growth—staving off the Great Recession and the suffering that came with it.Most pundits blame the housing market for the Great Recession. Under this approach, the Fed would commit to increase total nominal spending by four or five percent every year. Throughout mid-2008, U.S. inflation remained positive, as NGDP began falling. The dollar strengthened against other currencies. If NGDP grows too quickly, monetary policy is too loose. Monetary policy should seek stable growth in nominal gross domestic product (NGDP). Taxes increased sharply at the beginning of 2013, and a few months later, U.S. government spending tightened because of sequestration. Instead, the Fed, terrified of inflation, kept interest rates too high for too long—causing NGDP to fall even further.To prevent such errors in the future, the Fed should switch from targeting inflation to targeting the level of NGDP. After the Federal Reserve effectively slashed interest rates to zero in response to the Great Recession, some doubted that there was much else it could do to accelerate the pace of recovery. Just as removing several chairs will leave some players sitting on the floor when the music stops, removing several percentage points of expected NGDP growth will leave too little revenue to employ the existing work force at the wages they have negotiated. Starting with the recessionary period itself, McGranahan and Berman show that fiscal policy was more expansionary during the Great Recession than in any other recession since 1960. There were two distinct problems: banking distress caused by defaults on subprime mortgages and a much more serious macroeconomic crisis caused by the shortfall in spending. But total nominal spending would rise at a slow yet predictable rate.This approach has another appealing feature: it would send a clear and credible signal to the markets that the Fed would do what it took to get NGDP back on its long-term trend line. The supply of money will no longer be growing quickly enough to pay everyone’s wages. This is a familiar phenomenon. And something similar happened in the United States and the eurozone during the Great Recession.When the housing crisis hit at the end of 2007, defaults on reckless subprime mortgages put the U.S. banking sector under stress. Yet the housing crisis was a distraction. Published by the Council on Foreign Relations But because the Fed did not want to boost nominal spending, in early October, it introduced a new policy: it started to pay interest on reserves that banks hold with the Fed. Individual sectors would still have their ups and downs, and financial institutions would still collapse from time to time. It doesn’t try to get back on track and make up for lost ground. That doesn’t mean that no banks would have failed, but it does mean that the crisis would have been milder.The main benefit of price-level targeting is that it assures markets that the price level will remain predictable in the long run. In December … Starting in June 2008, however, NGDP fell by roughly three percent in 12 months, to about eight percentage points below the pre-recession trend line.As NGDP fell, unemployment rose and spread from the housing sector to almost every part of the economy. And the financial crisis, initially triggered by the housing slump, became much worse. In order for capital and labor to shift easily from a declining sector to a growing sector, the total spending in an economy must continue to rise at a reasonable pace. The result: rising unemployment.Consider what happened in the U.S. labor market in the 1970s. Everyone would know that whatever happened, enough money would flow through the economy to generate the sort of growth in national income that was expected when wage and debt contracts were signed. Because the Fed would target the level of NGDP, if spending were too low one year, interest rates would fall to boost spending, and investors would know that NGDP growth the following year would be higher to make up the lost ground. Instead, US policymakers should adopt regulatory, credit, and monetary policies that can help stabilize the economy, allowing the creation of an environment for healthy growth in living standards. But they misunderstand how monetary policy really works.A low nominal interest rate in itself does not constitute an expansionary monetary policy; what matters is its value relative to the “natural interest rate,” the rate at which inflation and NGDP remain on target. If investors knew that the Fed would eventually print as much money as necessary to bring prices back up to the pre-recession trend line, asset prices such as stocks, commodities, and real estate would have fallen by much less. Companies had committed to pay workers based on revenue forecasts that proved inaccurate.A similar problem occurs in the credit market.
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