It´s good when something works both in practice and in theory!

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!

10 thoughts on “It´s good when something works both in practice and in theory!

  1. “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!”

    Even though they’re “little,” what are those doubts?

      • Marcus, I figured as much. but I have to say I’m amazed by that level of confidence, and no offense, but I’m always a little suspicious of such confidence. I’m only 100% sure of a few things (for example my own existence!). And I can describe what it would take to change my mind about just about anything else.

        Don’t get me wrong, I’m not questioning your expertise or your evidence, and I freely admit I have no expertise whatsoever on this subject. In fact, I’d be just as suspicious of an economist expressing their unmitigated confidence about you being wrong. The thing is, I wouldn’t be surprised at all to find an economist that’s confident that you’re wrong. I’d think it’d be an easy task to find one. In contrast, I’d be very surprised to find a physicist disputing the theory of quantum mechanics (especially with any confidence!): a subject I’m just as ignorant of.

      • … just for completeness, I’d be very suspicious of a physicist’s high confidence level in a theory about what preceded the big bang… and I’d expect it’d be easy to find physicists with different ideas there. In fact, I’d be very surprised to find a physicist with more than a tiny bit of confidence about that subject. I’d expect most physicists supporting one view or another could rattle off with ease the evidence it would take to change their minds on the subject: and I’d expect broad agreement amongst physicists about the potency of that mind changing evidence. I can’t think of a thing in econ that economists would all agree to regarding mind changing evidence. But then I’m pretty ignorant. Can you think of something?

      • Sorry, I realize this is a blog, not a paper for publication. Erase my comments above if you like… I always get carried away on that subject (i.e. “How do you know?”).

  2. Tom, you´re “suspicious” by nature! I think that if a CB is doing a reasonably good job of targeting nominal spending along a level path, it´s almost “physically impossible” for interest rates to go to zero. For example, places like Australia, Israel and Poland, where NGDP was kept pretty close to the trend path in 2007-12, never saw rates go anywhere near zero.

    • Marcus, yes, maybe too suspicious. I don’t dispute your evidence, so let me ask you this: in spite of the evidence you’ve already seen, what new evidence would it take to convince you that you’re wrong? How could you tell that a CB had done a “reasonably good job” and yet the rates had gone to zero anyway? What would that scenario look like? Or is that literally impossible because, by your definition, “doing a reasonably good job” precludes rates going to zero?

      For example, I can imagine a military commander performing “brilliantly” by every measure and yet still losing the battle, perhaps because of circumstances beyond his control.

      • Tom, your comment reminded me of “To dream the impossible dream, to fight the unbeatable foe…”. What precludes rates going to zero is a sufficiently positive NGDP growth. In particular one that doesn´t let you fall off the trend path.

      • If “doing a good job” always implies “not letting rates go to zero” then is “doing a good job” a useful concept? Hypothetical conversation:

        President: “You did a terrible job, which caused you to lose the battle.”
        General: “I did everything I could. What do you suggest I could have done better?”
        President: “You could have won the battle.”

  3. You’re fast with your replies Marcus. (My last was posted before I saw your last). Thanks for your replies!

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