I visualize it like this – consider the graph showing nominal demand (a) which is determined by monetary policy. You may observe it as money supply versus money demand needed for that level of NGDP (equation of exchange). Lets say its a two good economy. On one axis is one good (investment) on the other, is the alternative good (investment). Lets arbitrarily say that A represents some long term equilibrium. (I did this in word so it may look a bit crappy, Im open for suggestions on other tools to draw things like this)
B represents some supply shock induced deviation. Now, in NGDPLT monetary policy is neutral. It should keep the nominal demand stable on the path. All the reactions can happen in a stable nominal environment. Shaded are shows the distortion and the loss of the nominal income.
That results in move from a -> b.
Nominal income deviated from the path as a result. Now, in growth rate targeting regime (or inflation targeting), this would be fine and CB wouldn’t have to make up for the “mistake”. If you regard NGDP as a stance of monetary policy, b would mean the MP is tight.
When the nominal environment deviates as well, you have a “double” problem, creating a sort of feedback loop. Nominal income falls – for example, cash flows from all MBS, not just those which were subprime or some other that are in “trouble” are affected. Now, general nominal AD may deviate from the “optimum”, but monetary policy doing the level targeting, will do everything to make up for the shortfall (and bring the situation back to a+level target in t+1). It will be easier to allocate resources from distressed sectors then.
Now demand for subprime housing will decline, but other asset classes will not have problem with distressed prices. This crunch in a part of a market can occur if there is a general uncertainty (call it information asimetry?), counterparty risk on the markets, creating a vicious circle from market liquidity to funding liquidity, back to market liquidity and so forth, distorting all possible asset classes. In that moment money demand explodes further / velocity is falling. Then further decline (to point c) in nominal income because MP was tight is certain.
Why can’t the discovery of some other equilibrium/ return to A (if B was unsustainable) be easier in situation where money is tight? I think its because if some other healthy sector is affected by a fall in nominal income (tight policy – take a look at role of money in all markets) it will not be able to accommodate the adjustment.
If Fed responds to that money demand appropriately, it can prevent a widespread vicious circle we saw in 2008 and consequences of which people are still feeling around the world. Doing it now (from point c) makes it a lot harder, but NGDPLT can induce markets to do part of a heavy lifting as I was trying to show before. “Good” parts of the economy will continue to function since monetary policy isn’t affecting relative prices but is targeting agregate nominal incomes and ensuring cash flows related with such investment (going at least to b, preferably to a). So if you are talking about MBS, those with cash flows from subprime borrowers will likely become “toxic” and the misallocation of resources caused by the idea of granting these people access to loans to buy homes will have to be resolved . I would call this the structural part. On the other hand, other securities may still be of “good”, primarily transparent, value – because nominal incomes they generated and generated from them are not significantly affected by the crunch in the other market. Offcourse they wouldn’t be fully immune, but on the other hand these wouldn’t be caught in a firesales spiral caused by high money demand (think of Rowe’s story), which is not accommodated (to c). Lets call this “tight MP” part . (again, lets suppose some of primary dealers weren’t loaded with subprime MBS going bad)