On the poor man's NGDP targeting regime

The main idea: issue, sell and buy unlimited quantities of consols whilst sterilising all net resulting inflows and outflows for a bare-bones automatic NGDP targeting regime.  

0. Posts on this blog are ranked in decreasing order of likeability to myself. This entry was originally posted on 21.01.2025 and the current version may have been updated several times from its original form. 

1.1 Earlier I have written about a thought experiment used to model the fiat economy. I actually think that model is good enough that the real-world complications and ways in which reality differs from it are minor.

1.2 Minor enough that simplifying reality to fit the model would actually enable us to come up with a decent automatic NGDP targeting regime, absent complicated instruments like futures and whatnot.

1.3 So here it goes. You have a Monetary Authority tasked with three duties: husbanding foreign exchange reserves, bailing out failing banks and issuing and buying back consols, the last two of which are the only way it can interact with the local economy and create money for.

1.4 The first duty is a familiar to any investment firm and of the second I’ve written about previously, so let’s focus on the third.

1.5 The Authority auctions off a number of consols that will pay out a constant stream of revenue every month forever. It is important that the value issued should be less than the foreign reserves stock for reasons that will become obvious. All receipts are reissued in the economy by buying out foreign currency.

1.6 Note how the auction sets the price of these instruments, and thus the nominal yield. 

1.7 The Authority now pledges to issue and buy back an infinite number of these instruments at the price that was discovered in the auction, forever (or thereabouts, see 1.14). Tasked with money creation, it can credibly pledge this. 

1.8 At this time, and assuming this promise is credible, the yield of these consols becomes the expected NGDP growth rate, immediately, with a huge shuffle of all intertemporal liabilities denominated in the local currency being set off to ensure this. 

1.9 Every fortnight, the Authority calculates the net inflows or outflows that it received from or paid to the market to sustain this pledge, ignoring the coupon payments. It then sterilises this sum by buying or selling from its foreign reserves over the following month.

1.10 This makes sure than the yield of the instruments becomes the expected as well as actual NGDP growth path. Every deviation from this rate translates into the market selling to or buying from the Authority, which inflows are sterilised for an iterative and entirely automatic process that brings NGDP back to target. 

1.11 As long as foreign reserves comfortably cover the original issue of consols and then some, credibility will be fine. Any additional issue from then will mean inflows which will require sterilisation in the form of adding to our foreign reserves.

1.12 The only issue would be a major appreciation of our currency’s value in terms of those currencies held in reserve, such as to make the sterilisation of large and sudden enough buybacks impossible to honour. Whilst I’m not sure how such an exchange rate zoom would come about given our local yields are credibly fixed, let’s assume so. First of all, a nice problem to have.

1.13 Second of all, even such a cataclysm as above would simply mean that the second bit of the mechanism, the one where we sterilise flows to make sure that expected NGDP growth translates into actual growth, breaks down. NGDP growth will continue to match our yield, but the base its growing from will be subject to this one random shock.  

1.14 Now, for a proper NGDP regime calque, set pre-determined check point at which the yield can be amended by pre-determined amounts. Say, the Monetary Authority (or, better still, Parliament) can change the yield (the price) by no more than ±1% every five to ten years. This is done to make sure than the rate evolves in reasonable lockstep with real GDP growth.

1.15 And there you have it, a nearly entirely automatic NGDP targeting regime and third world country can institute today.