Facts, Fears, and Functionality of NGDP Level Targeting: a Guide to a PopuLar Framework for Monetary Policy David Beckworth
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Facts, Fears, and Functionality of NGDP Level Targeting: A Guide to a Popu lar Framework for Monetary Policy David Beckworth SPECIAL STUDY David Beckworth. “Facts, Fears, and Functionality of NGDP Level Targeting: A Guide to a Popu lar Framework for Monetary Policy.” Mercatus Special Study, Mercatus Center at George Mason University, Arlington, VA, September 2019. ABSTRACT Nominal GDP level targeting (NGDPLT) has become an increasingly popu lar mon- etary policy framework over the past de cade. This rising popularity has led to increased interest in, as well as some confusion over, how this framework actually works. This paper attempts to address this interest by summarizing basic facts of NGDPLT and addressing some of the fears surrounding it. The paper also dem- onstrates how NGDPLT might work in practice. JEL codes: E50, E52, E58 Keywords: nominal GDP targeting, NGDP, nominal income targeting, monetary policy frameworks © 2019 by David Beckworth and the Mercatus Center at George Mason University This paper can be accessed at https://www.mercatus.org/publications/monetary -policy/facts-fears-and-functionality-ngdp-level-targeting-guide-popular The views expressed in Mercatus Special Studies are the authors’ and do not rep- resent official positions of the Mercatus Center or George Mason University. MERCATUS CENTER AT GEORGE MASON UNIVERSITY 2 CONTENTS Introduction 5 I. Facts about Nominal GDP Level Targeting 7 Fact 1: NGDPLT Is a Dollar-Denominated Target 7 Fact 2: NGDPLT Is a Growth-Path Target 7 Fact 3: NGDPLT Is a Velocity-Adjusted Money Supply Target 9 Fact 4: NGDPLT Is a Work-Around to the Supply Shock Problem 11 Fact 5: NGDPLT Is a Work-Around to Incomplete Financial Markets 14 Fact 6: NGDPLT Is an Anti–Zero Lower Bound Tool 16 Fact 7: NGDPLT Is a Way to Do Rules-Based Monetary Policy 17 II. Fears about Nominal GDP Level Targeting 19 Fear 1: Changes in Potential Real GDP Will Create Problems for NGDPLT 19 Fear 2: Data Revisions Make NGDPLT an Impractical Framework 20 Fear 3: The Public Will Not Understand NGDPLT 22 Fear 4: NGDPLT Does Not Satisfy the “Price Stability” Part of the Dual Mandate 23 MERCATUS CENTER AT GEORGE MASON UNIVERSITY 3 Fear 5: NGDPLT Does Not Address Financial Stability Concerns 26 Fear 6: Overshoots of an NGDP Target Would Be Politically Tough to Correct 26 Fear 7: NGDPLT Is Too Radical. Why Not Settle for Price Level Targeting? 27 III. Functionality: How to Implement Nominal GDP Level Targeting 28 IV. Conclusion 31 Appendix. Supply Shocks in a Monetary Policy–Phillips Curve Model 32 I. The MP-PC Model 32 II. A Temporary Supply Shock 33 III. A Permanent Supply Shock 35 Notes 37 MERCATUS CENTER AT GEORGE MASON UNIVERSITY 4 INTRODUCTION oes the Federal Reserve need a new mone- One proposal for revamping the monetary tary policy framework? A growing number policy framework is for the Federal Reserve to Dof observers believe the answer is yes. Some adopt a nominal GDP level target. This approach see the Great Recession, the slow recovery from it, would have the Fed target a stable growth path and the per sis tent shortfall of inflation relative to for the total amount of spending in the economy. its target as evidence that the current approach to While not a new idea, nominal GDP level target- monetary policy is inadequate.1 Others worry that ing (NGDPLT) became popu lar in the aftermath the secular decline in interest rates is permanent of the Great Recession.3 and leaves insufficient room for the Fed to cut This rise in popularity can be seen in panel A interest rates in future recessions.2 These concerns of figure 1, which shows the results of Google and have caused many to call for an overhaul of the way Google Scholar searches for NGDP targeting. the Fed does monetary policy. Panel B of figure 1 indicates that not only does FIGURE 1. GOOGLE SEARCH RESULTS FOR ARTICLES ON NOMINAL GDP TARGETING Panel A. NGDP Targeting Search Panel B. Monetary Policy Frameworks Searches 180 5,000 5,000 160 140 4,000 4,000 120 3,000 100 3,000 80 All Articles All Articles 2,000 2,000 60 Scholarly Articles 40 1,000 1,000 20 0 0 0 1983 1988 1993 1998 2003 2008 2013 2018 2000 2003 2006 2009 2012 2015 2018 All Articles: Google Search Price Level Targeting Scholarly Articles: Google Scholar Higher Inflation Target Nominal GDP Targeting Note: The search criteria used for nominal GDP targeting are as follows: “nominal GDP targeting” or “nominal GDP target” or “NGDP targeting” or “NGDP target” or “nominal income targeting” or “nominal income target.” For price level targeting, the search criteria used are “price level targeting” or “price level target.” For the higher inflation target, the search criterion is “higher inflation target.” The total number of search results for each year are used and were pulled from Google on April 9, 2019. MERCATUS CENTER AT GEORGE MASON UNIVERSITY 5 NGDPLT remain popu lar, but it appears to be placed. This paper illustrates why by clarify- generating more interest than some other mon- ing what exactly NGDPLT is and by addressing etary policy framework proposals, such as price the misconceptions about it. Ultimately, this level targeting or a higher inflation target.4 paper shows that this monetary policy framework Like many popular phenomena, however, can be implemented in a stabilizing manner. NGDPLT has been misunderstood by some To that end, this paper provides a guide to observers, and this has led to confusion over what the facts, fears, and functionality of NGDPLT. It it would mean for monetary policy. Some believe, does so in an accessible and executive-summary- for example, that it would fail to anchor inflation styled format so that interested parties can easily expectations or that it would increase economic find specific issues surrounding NGDPLT while volatility.5 Others worry that NGDPLT is an still being able to get a complete picture of this impractical framework for monetary policy approach to monetary policy. The paper first looks because of changes in potential real GDP, data at seven facts and seven fears regarding NGDPLT. revisions, public confusion, and the mechanics of It then shows how NGDPLT might be imple- implementing it. mented in practice. The paper concludes with While all of these concerns about NGDPLT some practical suggestions for making the tran- are understandable, they are ultimately mis- sition to NGDPLT. MERCATUS CENTER AT GEORGE MASON UNIVERSITY 6 I. FACTS ABOUT NOMINAL GDP LEVEL TARGETING FACT 1: NGDPLT IS A DOLLAR- where P is the price level and Y is real income. DENOMINATED TARGET Real income is inflation-adjusted income and is NGDPLT anchors the dollar size of the US econ- the real gains from working in the economy. omy. This mooring is accomplished by having Since NGDP = NGDI, (1) and (2) can be combined the central bank target the level of total dollar to get the following: spending in the economy. The total amount of MV = PY. (3) money spent, in turn, generates an equal amount of money earned in the economy. The former is Equation (3) is the famous equation of officially called nominal gross domestic product exchange, an accounting identity that relates (NGDP), while the latter is called nominal gross money transactions to money incomes. It implies domestic income (NGDI).6 Because these are that an NGDP target that stabilizes MV is equiva- equal, NGDPLT can be viewed as a target for lent to a nominal income target that stabilizes PY. both total dollar spending and total dollar In either case, the monetary policy goal is a income earned. As a consequence, some com- dollar- denominated target. mentators call this approach nominal income All of this means, as mentioned earlier, that targeting. NGDPLT anchors the dollar size of the economy. To better understand this connection, note Put differently, NGDPLT is a nominal anchor that that total dollar spending on the economy is keeps the growth of prices, wages, and other equal to the stock of money multiplied by how dollar- denominated activity moored so that often it is used. This decomposition of NGDP can they do not expand too rapidly. be summarized as follows: NGDP = MV, (1) FACT 2: NGDPLT IS A GROWTH- PATH TARGET where M is the total amount of money and V is NGDPLT requires the Fed to stabilize the level or the velocity, the number of times money gets growth path of NGDP. This means the Fed would used. Total dollar income can similarly be decom- have to make up for past misses from its target so posed into two parts: the price level times real that the targeted dollar level of NGDP is always income. This can be summarized as follows: maintained. This is illustrated in figure 2. It NGDI = PY, (2) shows a scenario where the Fed is targeting MERCATUS CENTER AT GEORGE MASON UNIVERSITY 7 FIGURE 2. A NOMINAL GDP LEVEL TARGET Panel A. Correcting for Below-Target Growth Panel B. Correcting for Above-Target Growth Nominal GDP Level Target Nominal GDP Level Target h Target Target Growth Path Growth Pat Slow-down Growth ) ) Catch-Up Growth h NGDP (Dollars NGDP (Dollars Target Growth Pat Target Growth Path Y1 Y2 Y3 Y4 Year (Yt)Y1 Y2 Y3 Y4 Year (Yt) some growth rate— the slope of the line— for NGDP set of rows shows what happens when NGDP and makes up for periods of below- and above- grows below 4 percent in 2019 (Y1). The missed target growth so that the trend growth path is growth is made up in the next two years by hav- maintained.