On the Desirability of Nominal GDP Targeting
September 14, 2015
Although nominal GDP targeting has recently received a lot of attention in the press and within policy circles, it has not been carefully analyzed within the context of the quantitative frameworks commonly used by central banks.
A study was conducted to compare the welfare benefits of nominal GDP targeting to other popular targeting rules: inflation and output gap targeting.
In one version of the model in which only prices are sticky, stabilizing inflation also stabilizes the output gap, and vice-versa. Given that inflation is easily observed at high frequencies, inflation targeting is often touted as a highly desirable and easily implemented policy rule.
But if both prices and nominal wages are sticky, then the central bank is unable to fully implement the flexible price and wage allocation. Thus, inflation targeting tends to perform poorly from a welfare perspective.
By contrast, nominal GDP targeting simultaneously targets both nominal and real variables, but unlike output gap targeting, it does not require the central bank to observe the hypothetical flexible price and wage level of output.
The findings about nominal GDP targeting relative to other policies are:
- Nominal GDP targeting performs best in a relative sense when wages are sticky concerning prices and conditional on supply shocks.
- When wages are rigid and prices are flexible, nominal GDP targeting is equivalent to gap targeting.
- When wages are flexible and prices rigid, inflation targeting outperforms nominal GDP targeting.
The authors conclude that nominal GDP targeting may produce lower welfare losses than gap targeting if the central bank has difficulty measuring the output gap in real time and suggest that nominal GDP targeting is an alternative policy that central banks ought to consider seriously.
Source: Julio Garín, Robert Lester and Eric Sims, "On the Desirability of Nominal GDP Targeting
" Cato Institute, August 12, 2015.
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