Wednesday, March 24, 2010

A case for nominal GDP growth targeting

This is wonkish, but a case for nominal GDP growth targeting instead of inflation targeting (which the US does not do explicitly but does do implicitly):
"inflation targeting at any rate is merely responding to the symptom not the underlying causes--shocks to aggregate demand (AD) and shocks to aggregate supply (AS)--of macroeconomic volatility. This is problematic because monetary policy can only meaningfully counter AD shocks and therefore, it must be able to discern which shock is driving inflation. Inflation, however, can be hard to interpret. For example, if there is a sudden burst of inflation is it due to a positive aggregate demand shock (e.g. sudden, unsustainable increase in household spending) or a negative aggregate supply shock (e.g. temporary spike in oil prices)? In the former case inflation targeting would act appropriately by reigning in excess spending while in the latter case inflation targeting would only make matters worse by further restricting economic activity. Rather than targeting inflation, then, monetary policy should directly target the underlying  source of macroeconomic volatility over which it has real influence, AD.  Doing so would have gone a long way in making  the U.S. economy during the 2000s more stable...
inflation targeting is only effective when  AD shocks are the main source of macroeconomic volatility.  If AS shocks are also important,then inflation targeting can be destabilizing.  Second, a far more effective approach to  minimizing macroeconomic volatility is to stabilize AD.   In the above scenarios, stabilizing AD growth  around a 5% target was all that was needed."

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