Nominal GDP Targeting

Nominal GDP (NGDP) targeting seems to be getting a lot of attention. The idea seems to go back at least to the 1980s, when Bennett McCallum talked about it. Scott Sumner and David Beckworth have taken this up as a cause, and Charles Evans has discussed NGDP targeting in a speech. Some of the business media think it matters.

To make sense out of NGDP targeting, start with the original Taylor rule, as specified in Taylor's 1993 paper. Taylor proposed that monetary policy should be conducted according to the following rule:

R(t) = p(t)- p(t-1) + a[y(t) - y*] + b[p(t) - p(t-1) - i*] + r*,

where R is the fed funds rate target, p is the log of the price level, y is the log of real GDP, y* is the target level of real GDP, i* is the target inflation rate, r* is the long-run real interest rate, a > 0 and b > 0. Taylor did not derive his rule using theory, but instead argued that this rule worked well according to some loss criterion in some macroeconometric models. The Taylor rule found its way into New Keynesian (NK) models, and into monetary policy discussions. Taylor rules have been derived in NK models, though the arguments are a little slippery. Generally, an optimal policy rule in a NK model would be some relationship between the policy instrument(s) and exogenous variables, but of course real GDP and the price level are endogenous, so one has to go through some contortions to coax the Taylor rule out of any model. The argument would seem to rely on what is observable to the central bank and what is not.

So, suppose that the central bank adopts a NGDP target. Then, the central bank must also have an approach to implementing such a target. Presumably the advocates of NGDP targeting think that standard central banking practice works, i.e. that a sensible approach to policy over the very short term is to specify an intermediate target for the fed funds rate, with the target set according to the current state of the economy relative to the NGDP target. Thus, we could specify the implementation of the NGDP target as a rule

R(t) = p(t) - p(t-1) + c[y(t) + p(t) - y* - p*] + r*,

where y*p* is the log of the nominal GDP target and c > 0. We can then rewrite this rule as

R(t) = p(t) - p(t-1) + c[y(t) - y*] + c[p(t) - p(t-1) - p* + p(t-1)] + r*

What's the difference between this and the basic Taylor rule? Not much. (i) The coefficients on the terms governing the response of the fed funds rate to the "output gap" and the deviation of the inflation rate from its target are constrained to be the same. (ii) The interpretation of y* may be different. In the NK literature y* is the efficient level of aggregate output ground out in the underlying real business cycle model. The NGDP targeters seem to think of y* as the trend level of output. For practical purposes it does not make much difference, as the people who measure output gaps tend to think of trend GDP as potential GDP. (iii) The target inflation rate is not a constant, but the percentage deviation of the target price level from last period's inflation rate.

In sum, the NGDP rule fits well within the set of Taylor rules that people have considered, which deviate in various ways from the basic rule that Taylor wrote down in 1993. So what's new? Could it be that there is something different about what happens at the zero lower bound, which I have not accounted for thus far? Suppose we are at the zero lower bound, which is essentially the case currently, and the Fed announces, say, a target path for NGDP of 5% per year indefinitely. Could the Fed actually achieve such a target, even if it wanted to? No. Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target.

There is no magic in a NGDP target. I know people look at the state of the economy, and think that the Fed should keep trying things. Maybe something will work? Well, I'm afraid not. Even the FOMC dissenters, and their supporters are not quite ready to say that there is nothing the Fed can do under the current circumstances that could increase employment. But they should.