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Joshua Bates
Dr. Kiser
Econ 7391
1 May 2012

What is NGDP Targeting and Could it Help?

The economy is ugly.  Greg Mankiw calls it a “So-called Recovery” in a headline overlooking a graph of the employment-population ratio; the graph is a nose dive starting in 2008 and has done little to improve since (2012).  With a large fiscal stimulus in 2009 and the federal funds rate against the zero lower bound, policy appears to be out of options; there is no political will in congress to enact fiscal stimulus, and inflation hawks at the Federal Reserve cause it to be too cautious with its monetary policy.  Clive Crook summarizes the problem:

Slow growth, high unemployment and less-than-target inflation: On the face of it, an open-and-shut case for another round of quantitative easing. The trouble is, nudging up expectations of inflation is implicitly part of what QE is intended to do. That shouldn’t be a problem when expected inflation is running so low, but it is -- an aspect of the policy that dares not speak its name. The Fed is reluctant to look as though it’s taking chances with its goal of price stability. (2012)

The solution to this issue is a policy rule.

            The main problem with the Fed’s current actions is that it is politically difficult to carry out the necessary actions.  Discretionary monetary policy has led to problems committing to the correct actions to fix the high unemployment; a rule would help disarm opponents of inflationary actions by allowing the FOMC to commit to actions correcting unemployment now and inflation later if it becomes a problem.  According to Dr. Taylor, “Under pure discretion, the settings for the instruments of policy are determined from scratch each period with no attempt to follow a reasonably well-defined contingency plan for the future” (1993, 198).  By this definition of discretion, there is no commitment device that would constrain future inflationary behavior, if it benefits policy makers.  A rule would allow current makers of policy to credibly commit to keeping the economy on a steady course, regardless of the necessary actions.  Milton Friedman supported this idea, saying that, “By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability” (1968).  This would all imply that a new rule is in order.  Nominal income targeting is a simple, feasible rule that can either augment or replace current decision variables; it would likely have some effect upon implementation, but it will take time to realize most of the benefits.

            Having read much of this research spanning several decades, it is quite plausible to assume that the Fed follows a rule of some kind already.  According to the Fed Chairman Ben Bernanke, the Fed utilizes flexible inflation targeting that, “combines commitment to a medium-run inflation objective with the flexibility to respond to economic shocks as needed to moderate deviations of output from its potential, or ‘full employment,’ level. The combination of short-run policy flexibility with the discipline imposed by the medium-term inflation target has also been characterized as a framework of ‘constrained discretion’" (2011).  It is this “constrained discretion” that is at the heart of the Fed’s inability to be more aggressive in the face of persistent economic woes.  Nominal income targeting, however, would “commit Fed officials to more-disciplined policymaking” (Koenig 2012, 2).  This, of course, depends on the design of the rule and its implementation.

            Hall and Mankiw make a few early approximations of potential nominal income targets the first consists of a growth target, the second, a level target and the third, a hybrid.  In this case, nominal income is equal to the price level plus real GDP or .  Growth rate targeting calls for keeping the growth of nominal income equal to a trend growth plus an error term or  where mu is the trend growth and epsilon is the error.  Since it is only concerned with income growth in the current period, past shocks do not affect the target in the current period; this could “worsen business-cycle fluctuations by always causing the economy to overshoot its equilibrium after-shocks” (Taylor 1985, 81).   Level targeting fixes this by setting ; in this case, if growth has been anemic previously, today’s income target is higher than it would have been under a growth target.  Hall and Mankiw also consider a hybrid rule that targets nominal income growth rates, but allows the target to be corrected for output deviations, written as  where the last term is the difference between potential and realized real income. 

Finally, Hall and Mankiw attempt to predict the effects of implementing these rules, and they conclude that “the primary benefit of nominal income targeting is reduced volatility in the price level and inflation rate” compared to discretionary policy (1993).  In their opinion, “none of these policies clearly dominates all the others, although growth-rate targeting seems to yield the least desirable outcomes” (Hall and Mankiw 1993).  This outcome is somewhat expected due to the earlier criticism of growth rate targeting.

Despite the apparent need for a new rule and its support, John Taylor has been opposed to nominal income targeting as a rule.  In 1985, he wrote that, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations” (Taylor 1985, 81).  More recently he described the lack of specific instruments in most nominal income rules as “the wolf dressed up as a sheep, it is discretion in rules clothing” (Taylor 2011).  This led to the creation of the Taylor rule, a policy rule that prescribes an interest rate based on inflation and income growth over the previous year or  where r is the federal funds rate, p is the inflation over the past year and y is the percent deviation of real GDP from a target (Taylor 1993, 202).  This appears to be the policy rule used to guide the Fed; Paul Krugman noted in 2009 that, “the [Goldman Sachs] version of the Taylor rule tracks actual Fed behavior very well — up to now.”  He also notes the inadequacy of the Taylor rule at this point:

But looking forward, the Taylor rule says that the Fed should cut rates a lot from here — in fact, to negative 6%. That’s not surprising: we’re clearly opening up a huge output gap, inflation is turning into deflation.  The problem, of course, is that you can’t cut interest rates below zero (if you try, lenders will just hoard cash.) So the Fed simply can’t do what the rule says it should. (Krugman 2009)

The lack of a specific instrument in the case of nominal income targeting is a strength as opposed to a weakness.

            Despite his distrust of the implementation of nominal income targeting, Taylor does approve of the idea.  To close his 1985 paper, Taylor gives nominal income goals a ringing endorsement:

But whether a nominal GNP rule, another rule, or even no rule at all is instituted, focusing policy discussions on nominal GNP would in my view greatly improve policy performance.  The aims of policymakers would be much easier to interpret if their goals for nominal GNP were clearly stated.  The Fed in conjunction with the Congress and the administration should state realistic forecasts of nominal GNP growth conditional on their intended plan for monetary and fiscal policy.

This section is informative, because the concepts behind the Taylor rule and NGDP targeting are the same.  In fact, Koenig points out that “suitably implemented, nominal-GDP targeting is the more-familiar Taylor rule’s close cousin. The main difference between the two policy approaches is that nominal-GDP targeting takes a longer-term view of inflation than does the Taylor rule when pointing to a loose or tight policy setting” (2012).  In this way, it could be said that a form of nominal income targeting is already in use, if we take the Taylor rule’s use in setting monetary policy as given.  If this is the case, exactly how a nominal income rule would differ from current policy must be specified.

            As luck may have it, one country has already adopted a form of nominal income targeting.  Germany used nominal income targets from 1974 until the advent of the European Monetary Union.  Domac and Kandil describe the German system:

The Bundesbank started, therefore, to announce annual targets for the growth of the [Central Bank Money Stock] in December 1974 until 1988.  Thereon, the Bank has relied on M3 as an intermediate target variable.  Annual monetary growth targets are based on quantified assumptions of the economic developments aimed at in the year in question.  This makes it easier for economic agents to adjust prices, wages and incomes to the policy of the central bank.  Furthermore, the Bundesbank follows a policy of nominal income targeting in which nominal income is the ultimate target.  Under this approach, policy makers use nominal income targets to determine appropriate targets for monetary aggregates. (2002)

The quantity theory of money completes the picture.  As Ed Dolan states, “Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth” (2011).  Although the simplifying assumption of a constant V is not accurate, this shows a rather direct link between the size of the monetary base and nominal income; this is the instrument that theoretical nominal income rules lacked.

            Implementation in the United States would have to be a careful process.  Taylor outlines the difficulties of the transition period between policies writing that “People will have adjusted their behavior to the policy in place…in the period immediately after a new policy rule has been put in place, people are unlikely either to know about or understand the new policy or to believe that policymakers are serious about maintaining it” (1993).  Koenig outlines a solution to these obstacles by making sure that “firms and households be told well in advance what the target is going to be—far enough in advance that a large fraction of existing labor and debt contracts will expire before the target takes effect” (2012).  He recommends a target five or more years in advance; he specifies that “It takes about five years for the sum of the inflation and output gaps to get back to zero once it has moved away” (Koenig 2012).  Five years warning appears to allow expected inflation and output to converge with realized inflation and output.  Finally, Koenig computes a nominal income targeting rule where  or realized inflation is equal to target inflation minus the output gap between realized and expected output over time T.  If realized inflation is lower than this target, the Fed should expand the monetary base and vice versa.  Given the similarities between the Taylor rule and nominal income targeting, it seems feasible that a more explicit target is possible.  Scott Sumner agrees, writing that “I wouldn’t say the Fed puts equal weight on inflation and RGDP growth, but Bernanke’s comments about the dual mandate suggest the policy is pretty close to NGDP (Nominal Gross Domestic Product) targeting” (2012).  It could be implemented; perhaps it should be implemented.

            Certainly nominal income targeting has its supporters; these tend to agree that this kind of targeting would have stabilizing effects now and into the future.  In response to the current predicament, Scott Sumner posits that, “Nominal GDP targeting, on the other hand, offers both a politically and economically sensible alternative, which would be far better equipped to advance stable growth, to overcome the politics of inflation, and to help the Fed avoid discrediting itself” (2012).  He completes his opinion by stating that, “It offers a single target that effectively combines both facets of the Fed's dual mandate, and so should be attractive to those on both the left and the right who argue that the requirement to simultaneously address inflation and unemployment makes it impossible for the Fed to tackle either very well” (Sumner 2011).  Paul Krugman sees nominal income targeting as a politically expedient way to accomplish his preferred policy, opining that, “say that we need to reverse the obvious shortfall in nominal GDP, and you’ve found a more acceptable way to justify huge quantitative easing and a de facto higher inflation target” (2011).  However, both of these defenses do little for the current climate; implementation would take years, and while the political economy argument would help future problems, it does not seem to do much for today’s issues.  Christina Romer, another nominal income supporter, acknowledges as much, stating that, “announcing the new framework would help, it probably wouldn’t be enough to close the nominal G.D.P. gap anytime soon” (2011).  Furthermore, historically growth lags monetary policy; according to the St. Louis Fed, “historical data tell us that if there is any positive association between money growth and GDP growth, the impact comes about 3 years after an initial acceleration of base growth” (Wen 2009).  The improved communication and certain target would probably help, but not for a few years; it would not help the current crisis.

            Furthermore, there are some who are of the opinion that nominal income targeting would cause more problems than it would solve; just because it would solve the current crisis were it already in place, does not mean it would do well in more normal times.  Amity Shales reiterates John Taylor’s issue with nominal income targeting, writing that “ the big vulnerability of NGDP targeting is that it’s a license to inflate. It will inevitably undermine the Fed’s mandate to maintain price stability” (2011).  While nominal income targeting would not be pure discretion, the monetary base is not an instrument accustomed to fine tuning, with policy lags and other vulnerabilities to unintended consequences.  However, the German example shows that it can be done without adverse effect; Domac and Kandil conclude that “Overall, the empirical findings highlight the success of the Bundesbank’s concept of monetary policy and, thereby, lend support to the implementation of the policy of nominal GDP targeting in practice” (2002, 198).

            Another, more technical problem could arise.  Currently the Fed is restricted in the types of assets it can buy to expand the monetary base; perhaps the amount of expansion needed is larger than the value of all of the assets it can buy.  Daniel Neilson elaborates, “When the Fed buys assets from ‘the public’, only a very specific part of the public is meant—commercial banks and securities dealers. These may be able to find lots of things to do with the money thus obtained other than spending it on newly produced goods and services” (2011).  He notes that if a truly massive action is required, the independence of the Fed may be revoked by Congress, fearing future inflation and not buying the nominal income targeting argument.  Neilson finishes by concluding that if households and businesses are deleveraging, a vital link in the supply chain of money is broken; people cannot take on more debt, so with tepid demand for loans, the money sits in a vault at the Fed.  If the Fed were to have problems reaching its target, particularly in its first time out, the credibility that goes with more transparency and all its benefits disappear rather spectacularly.  The solution to this would be for the Fed to buy any asset from anybody; the Fed would become the market maker of last resort.  Podcasting for the Library of Economics and Liberty, Scott Sumner notes that “in reductio ad absurdum, the Fed would buy up all of planet Earth and pay for it with currency” (Roberts 2012).  While this seems to solve the problem of who gets the money, it does not solve the threat to independence, and it brings its own set of practical issues with it.

            Despite these qualms, nominal income targeting does provide monetary predictability with built in automatic stabilizers in a form that is eminently feasible.  The rule would provide modest benefits if implemented immediately; indeed, there may be good reason to delay implementation until a more normal situation arises.  However, it would be a desirable long term policy solution.  The positive German experience with it increases the credibility and the attractiveness of such a policy.  If it replaced the dual mandate, there would be little the Fed would have to do to change; they would merely have to announce a target that they are likely going for anyway.  Clive Crook describes the effect of replacing the dual mandate, “With a simpler goal -- one it could actually achieve -- the Fed would have less to argue about and less to explain. It would be more accountable. And transparency would provide clarity, which is stabilizing, rather than the current muddle, which isn’t” (2012).  Nominal income targeting would not fix today’s problems and could not fix the structural issues that plague the economy; however, it would go a long way towards repairing today’s damage and preventing tomorrow’s

           

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