Why Nominal GDP Targeting?

Nominal GDP (in logs) and approximate 6% trend since 1982
Nominal GDP (in logs) and approximate 6% trend since 1982

Probably the best example that blogging can have a significant influence on economic thinking has been Scott Sumner’s advocacy of nominal GDP (NGDP) targeting at his blog The Money Illusion (and more recently EconLog). Scott has almost singlehandedly transformed NGDP targeting from an obscure idea to one that is widely known and increasingly supported. Before getting to Scott’s proposals, let me give a very brief history of monetary policy in the United States over the last 30 years.

From 1979-1982, the influence of Milton Friedman led the Federal Reserve to attempt a policy of constant monetary growth. In other words, rather than attempt to react to economic fluctuations, the central bank would simply increase the money supply by the same rate each year. Friedman’s so called “k-percent” rule failed to promote economic stability, but the principle behind it continued to influence policy. In particular, it ushered in an era of rules rather than discretion. Under Alan Greenspan, the Fed adjusted policy to changes in inflation and output in a formulaic fashion. Studying these policies, John Taylor developed a simple mathematical equation (now called the “Taylor Rule”) that accurately predicted Fed behavior based on the Fed’s responses to macro variables. The stability of the economy from 1982-2007 led to the period being called “the Great Moderation” and Greenspan dubbed “the Maestro.” Monetary policy appeared to have been solved. Of course, everybody knows what happened next.

On Milton Friedman’s 90th birthday, former Federal Reserve chairman Ben Bernanke gave a speech where, on the topic of the Great Depression, he said to Friedman, “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” According to Scott Sumner, however, that’s exactly what happened. Many explanations have been given for the Great Recession, but Scott believes most of the blame can be placed on the Fed for failing to keep nominal GDP on trend.

To defend his NGDP targeting proposal, Scott outlines a simple “musical chairs” model of unemployment. He describes that model here and here. Essentially the idea is that the total number of jobs in the economy can be approximated by dividing NGDP by the average wage (which would be exactly true if we replace NGDP by labor income, but they are highly correlated). If NGDP falls and wages are slow to adjust, the total number of jobs must decrease, leaving some workers unemployed (like taking away chairs in musical chairs). Roger Farmer has demonstrated a close connection between NGDP/W and unemployment in the data, which appears to support this intuition

NGDP_Unemployment
Source: Farmer (2012) – The stock market crash of 2008 caused the Great Recession: Theory and evidence

We can also think about the differences in a central bank’s response to shocks under inflation and NGDP targeting. Imagine a negative supply shock (for example an oil shock) hits the economy. In a simple AS-AD model, this shock would be expected to increase prices and reduce output. Under an inflation targeting policy regime, the central bank would only see the higher prices and tighten monetary policy, deepening the drop in output even more. However, since output and inflation move in opposite directions, the change in NGDP (which is just the price level times output), would be much lower, meaning the central bank would respond less to a supply shock. Conversely, a negative demand shock would cause both prices and output to drop leading to a loosening of policy under both inflation and NGDP targeting. In other words, the central bank would respond strongly to demand shocks, while allowing the market to deal with the effects of supply shocks. Since a supply shock actually reduces the productive capacity of an economy, we should not expect a central bank to be able to effectively combat supply shocks. An NGDP target ensures that they will not try to.

Nick Rowe offers another simple defense of NGDP targeting. He shows that Canadian inflation data gives no indication of any changes occurring in 2008. Following a 2% inflation target, it looks like the central bank did everything it should to keep the economy on track

CanadaCPI

Looking at a graph of NGDP makes the recession much more obvious. Had the central bank instead been following a policy of targeting NGDP, they would have needed to be much more active to stay on target. Nick therefore calls inflation “the dog that didn’t bark.” Since inflation failed to warn us a recession was imminent, perhaps NGDP is a better indicator of monetary tightness.

CanadaNGDP

Of course, we also need to think about whether a central bank would even be able to hit its NGDP target if it decided to adopt one. Scott has a very interesting idea on the best way to stay on target. I will soon have another post detailing that proposal.