Wednesday, June 06, 2012

On NGDP targeting's sharing of risk between debtors and creditors:

There are lots of long-term contracts with payments fixed in nominal terms. Not just long term bonds, but things like pension plans and government transfer payments. We aren't very good at forecasting what real GDP wil be 10 or 30 years from today. Inflation or price level targeting gives the creditor full insurance against unforeseen changes in future real GDP, and puts all the risk upon the debtor. This doesn't seem to be an efficient or a fair way to allocate aggregate risk. NGDP targeting provides a 50-50 aggregate sharing of aggregate risk between creditors and debtors. If real GDP falls 10% below what was expected, the price level rises 10% above what was expected. The real incomes of both creditors and debtors fall by the same 10%.  It is unlikely that 50-50 sharing of that risk would be exactly first best in all circumstances, but it is probably better than a 0-100 allocation of that risk.

Sure, debt contracts can always be renegotiated. But the whole point of having a long-term contract is because you don't want to renegotiate it every year or every day when circumstances might change. If the expectation of renegotiation weren't a problem, we wouldn't have agreed to a long-term contract in the first place. "Here's $100; let's leave it open for future negotiation how much you pay me." That's not a contract. I might say that to my kids or close friends, but I wouldn't do business on that basis.


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