Friday, April 20, 2007

A case against Thomas Palley (fg)

Thomas Palley, one of the leading Post Keynesians, recently made a case against inflation targeting. His argumentation is not on technical issues or how such a conceptual framework can be best conducted; it is rather on theoretical grounds. An explicit inflation targeting framework ipso facto assumes money to be neutral with respect to growth and unemployment. He says this consensus is rooted in Friedman’s theory of a natural rate of unemployment (NAIRU) in wich monetary policy can promote anything than delivering price stability. Palley goes further by introducing the opposed consensus, i.e. money has real effects. He conludes that inflation targeting is inferior since in this framework inflation is the sole (nominal) objective. A real obejctive is missing.

Well, as you may guess, I find some points refuting this statement:
  • Did Palley ever heard from Svensson and his Flexible Inflation Targeting where there are (at least) two objectives in the loss function, i.e. inflation and output deviations?
  • I really don't find any economist of the critized consensus view claiming that monetary policy has no effects on both real and nominal outcomes (at least in the short-run)
  • It may be true that the theroetical consenus view sees potential output as an exogenous AR(1) process with an error term normally distributed and thereby, working with an equilibrium concept (DSGE). However, as Woodford showed, we could easily introduce endougenous capital accumulation where induced investment increases potential output.
  • But my main point refers to monetary policy practice. Since potential output is not oberservable for policy-makers in the conduct of monetary policy, it has to be estimated. A Hodrick-Prescott filter estimates potential output and the output gap on behalf of past output growth. Therfore, it becomes clear that monetary policy actually permitts potential output to be an endogenous variable depending on past growth performance!