NGDP targets: pros and cons

We shouldn’t expect a perfect tool for managing the economy, so in this section I want to summarise what I consider to be the three strongest reasons in favour of NGDP targets, and also the three strongest arguments against.

Three good reasons in favour:

1. They are good at dealing with supply shocks. An inflation target fails to reflect the reasons for inflation to either be above or below target, and therefore send dangerous signals to policymakers. If inflation is low because of a lack of demand, we need central banks to step in. But if inflation is low because of productivity improvements, then increased purchasing power is exactly what we want. Similarly, if too much aggregate demand is causing higher prices we want central banks to cool things down. But if a negative real shock is prompting prices to spike, the last thing we want is reduced spending, which which compound the negative economic activity. By asking central bankers to “see through” temporary inflation we’re expecting them to be able to make a judgment about the source of inflation. An NGDP target avoids having to do this – by keeping nominal income stable you let the price level adjust automatically to changes in productivity.
2. They promote financial stability. A big macroeconomic danger is that when debt burdens become unmanageable this tends to affect wide parts of the economy and has negative knock on effects. A NGDP target means that in a recession inflation will increase and this will erode some of the real value of those debt burdens. People tend to borrow a nominal amount, and inflation means that you pay back less, in real terms, than you otherwise would. This eases the consequences of high debt burdens.
3. They promote monetary neutrality. If V is people’s desire to spend money then we can recognise that it is the inverse of people’s desire to hold money, i.e. the demand for money. Like any market, equilibrium occurs when the demand and supply are able to adjust, and when it comes to money we want supply to adjust to changes in demand. Monetary equilibrium is therefore a consequence of NGDP stability. This also will keep interest rates at their “natural” rate, which is when the demand and supply of loanable funds is equal. Rather than using monetary policy to deliver an arbitrary inflation target, an NGDP target approximates a much more important macroeconomic objective: neutrality. It provides a platform where demand and supply interact, providing a stable and meaningful context for economic activity to take place.

Three good reasons against:

1. National income data isn’t ready yet. Reasonably accurate estimates of CPI are released every month. GDP by contrast tends to be available each quarter and subject to large revisions. Indeed some people argue that policy mistakes in 2008 were more due to the fact that GDP data was faulty rather than a blind commitment to an inflation target. But even if we had quicker estimates of GDP this isn’t necessarily what we should be focused on. Not all economic transactions are captured in GDP figures, which is a sort of middle ground between a measure of pure consumption of final goods (i.e. no capital goods at all) and the entire capital stock. It serves a useful purpose, but is hardly an accurate measure of what we actually care about. Some would argue that the “correct” form of the equation of exchange is M+V=P+T, where T refers to all economic transactions. But if we include financial transactions in our analysis, the real economy becomes virtually irrelevant. So perhaps a focus on payments data or “average weekly earnings” may be better suited to our objectives than GDP.
2. It will lead to greater inflation volatility. By switching to a NGDP target policymakers will be less inclined to ensure a stable rate of inflation. It’s debatable how successful they have been at delivering a low, moderate rate of inflation, but less focus on this may well reduce performance even more. Especially since Y* is subject to change, the choice of NGDP target will lead to quite high variations in inflation. There will also be some confusion amongst the general public, because at the moment we use CPI as our standard measure. However the “P” in M+V=P+Y is not best measured by a basket of consumer goods, it should be the inflation rate that affects the component parts of our GDP calculation. This is referred to the “GDP deflator”. It has taken central banks many years to generate credibility around their ability to get the general public to expect 2% inflation. Switching to a more volatile outcome of a different measure might be hard to explain.
3. Not all economies are suitable. An NGDP target is best suited to larger economies, because smaller ones (especially if their are open to trade) are likely to be reliant on particular commodities. For example, for small open economies (in especially those that are commodity exporters) if oil prices rise you would need to shrink the rest of the economy.