For the past several years, market monetarists have promoted the change from inflation targeting to NGDP level targeting. The analysis was mostly empirical, a fact that made some “wrinkle their nose”. A new model based paper arrives at the same conclusion:
The design of monetary policy has been the subject of a voluminous and influential literature. In spite of widespread discussion in the press and policy circles, the normative properties of nominal GDP targeting have not been subject to scrutiny within the context of the quantitative frameworks commonly used at central banks and among academic macroeconomists.
The objective of this paper has been to analyze the welfare properties of nominal GDP targeting in comparison to other popular policy rules in an empirically realistic New Keynesian model with both price and wage rigidity. We find that nominal GDP targeting performs well in this model. It typically produces small welfare losses and comes close to fully implementing the flexible price and wage allocation. It produces smaller welfare losses than an estimated Taylor rule and significantly outperforms inflation targeting.
It tends to perform best relative to these alternative rules when wages are sticky relative to prices and conditional on supply shocks. While output gap targeting always at least weakly outperforms nominal GDP targeting, the differences in welfare losses associated with the two rules are small.
Nominal GDP targeting may produce lower welfare losses than gap targeting if the central bank has difficulty measuring the output gap in real time. Nominal GDP targeting always supports a determinate equilibrium, whereas output gap targeting may result in indeterminacy if trend inflation is positive.
Overall, our analysis suggests that nominal GDP targeting is a policy alternative that central banks ought to take seriously.
There are a number of possible extensions of our analysis. Two which immediately come to mind are financial frictions and the zero lower bound. Though our medium scale model includes investment shocks, which have been interpreted as a reduced form for financial shocks in Justiniano et al. (2011), it would be interesting to formally model financial frictions and examine how nominal GDP targeting interacts with those.
Second, our analysis abstracts from the zero lower bound on nominal interest rates. It would be interesting to study how a commitment to a nominal GDP target might affect the frequency, duration, and severity of zero lower bound episodes.
On the last sentence, MM´s have little doubt that, when undertaken, the study will also corroborate their view that the frequency, duration and severity of ZLB episodes would essentially disappear!