I would like to follow up on my earlier post: NGDP Targeting in an OLG Model. The purpose of that post was to evaluate the desirability of an NGDP target policy within the context of an explicit (mathematical) macroeconomic model. Josh Hendrickson does a good job of explaining the motivation behind my approach here (and btw, thank you for the kind words, Josh.) Josh goes on to provide a list of reasons for why an NGDP target is a good policy prescription, but he does not really address the point I was trying to make with my simple model. And so, let me try again, this time in less technical terms.

First, let me describe the model economy I employed in my earlier post. The economy is populated by different types of people. At any point in time, there are people with relatively large wealth positions and high consumption propensities--and there are people with relatively small wealth positions who have high saving propensities. This is not a "representative agent" model economy: people are different--and these differences matter.

There are two types of assets in the economy, that I label "capital" and "money" (or government debt). I model capital as physical capital, but it should be clear that one may substitute any form of private investment in its place, including human capital investment, or recruiting investment (as would be the case for a labor-market search model). Capital investment is just a metaphor for any activity involving a sacrifice today for an uncertain return reward in the future. In the model, peoples' perceptions of this future reward (whether such perceptions are rational or not) are a key driver of investment demand (and hence, aggregate demand). Does this sound crazy? (I don't think so.)

The government money/debt plays an important role in this model economy. In particular, the competitive equilibrium turns out to be inefficient without it (there is a dynamic inefficiency). Of course, this does not mean that the government can print paper haphazardly. From a social welfare perspective, it will want to manage the supply of its paper in a particular way (that I will describe below).

There is a "sticky" nominal price in the economy: the nominal interest rate on government paper cannot be made contingent on any contemporaneous information (in particular, the expectations shocks that afflict investment demand). I imagine that one could also include nominal private debt (like mortgage debt), but it would not affect the qualitative results I report below. All other prices are flexible.

Now, let me describe how this economy behaves over time, assuming a "passive" government policy of keep the nominal supply of debt fixed.

There are two types of shocks: (1) a news-shock that affects investment demand (and so looks like an AD shock), and (2) a productivity shock that affects the ex post return on capital (and so looks like an AS shock).

Good news creates a rational optimism: investors revise upward their forecast over future returns to capital investment. Agents "dump" money/bonds and substitute in private securities. The money dump results in a surprise jump in the price-level. The real value of outstanding government debt declines. There is a redistribution of wealth from bondholders to investors.

The opposite happens when the news is bad (a productivity slowdown?). A sequence of bad news shocks results in a deflation. Capital spending contracts, and with it, future GDP. There is a redistribution of purchasing power away from investors toward bondholders that further depresses investment spending.

I claim that qualitatively, this model generates dynamics that most people would have a hard time distinguishing from the data. 

The optimal policy here turns out to be a price-level target (PLT). The role of the PLT here is to prevent variation in the real value of nominal debt that is not indexed to the price-level. Ex ante, agents want to avoid transfers of wealth stemming from uninsurable price-level shocks interacting with nominal debt.

So, if the news is bad, the government should increase the supply of money to accommodate the increase in demand for money (via the asset substitution induced by bad news over the expected return to investment). But if the news truly is fundamentally bad, the future real GDP should decline, and along with it, the NGDP should decline as well (it's decline is stemmed in part by maintaining the price level target). Stabilizing the NGDP in this context would mean increasing the price-level so high as to create a transfer of wealth from creditors to debtors (instead of debtors to creditors) --something these agents would have wanted to prevent ex ante if nominal debt could have been indexed to the price-level.

This was the gist of my argument. I was just curious to see what NGDP targeting advocates thought of it. What is missing in my model? Are frictions other than nominal debt required? I have a hard time seeing how the presence of sticky nominal wages or prices are going to alter my conclusion here. But who knows, maybe someone can tell me?

Note: If the expectation shocks I describe above are not rational (e.g., possibly psychological "animal spirits"), then obviously there is a role for NGDP (and RGDP) targeting. However, I don't really hear Scott Sumner and others making this claim (or do they?).