Nominal GDP Targeting and Supply Shocks

Adam P. continues his rather uncivil ways, claiming that my post is a "confused mess."

No doubt, this is due to my failure to communicate clearly. Adam P., think back to your principles of economics course, or, perhaps, to the many times you have taught the course over the years. An adverse aggregate supply shock shifts the aggregate supply curve to the left. The result is a higher price level and lower real output. To prevent the increase in prices, it is necessary to shift the aggregate demand curve to the left as well. While this partially or fully reverses or prevents the increase in prices, the decrease in real output is larger--at least if the short run aggregate supply curve has a positive slope.

He goes on about how "supply shocks" involve reductions in output that cannot be corrected by monetary policy. The standard approach would be that using monetary policy to prevent real output from falling in the face of an adverse supply shock requires that the aggregate demand curve be shifted to the right. This will at least temporarily dampen, prevent, or reverse the reduction in output. At least if the short run aggregate supply curve has a positive slope. Unfortunately, prices will rise by even more than would have occurred if there had been no monetary policy response.

Nominal GDP targeting approximates the "do nothing" response. The aggregate supply curve shifts to the left, and aggregate demand stays the same. The price level rises and real output falls.

I didn't mean to suggest that an aggregate supply shock won't lead to lower real output. My actual view is that a recession is a negative output gap, and so, if potential output falls, and real output was initially equal to potential output, then a recession would involve output falling by more than potential output. Further, it is possible, and perhaps likely, that supply shocks would raise the natural unemployment rate. A recession, on the other hand, would involve the unemployment rate rising above the natural unemployment rate. I believe this is exactly what would happen if aggregate demand is reduced in response to an aggregate supply shock to prevent inflation.

I think the best response to an aggregate supply shock would be one that leaves real output equal to the reduced level of potential output and the unemployment rate equal to the perhaps increased natural unemployment rate. It is almost certain that this would involve a higher price level.

I don't think that nominal GDP targeting will exactly accomplish this. It will if the demand for the particular market facing the decrease in supply is unit elastic. Otherwise, the situation is a ambiguous.

Adam P. shows some charts where he claims that the record of the seventies proves that a stable nominal GDP growth path would have adverse effects due to supply shocks. Of course, part of this was due to his odd assumption that I was claiming that aggregate supply shocks wouldn't impact unemployment if nominal GDP stayed on a stable growth path. He shows that the unemployment rate increased in the recession of 1974.

In reality, the growth rate of nominal GDP shows an upward trend during the period, but it is highly irregular. In particular, the recession of 1974 shows a clear reduction in the growth rate of nominal GDP. It looks like a 4 percentage point decrease out of 12%, and so that is about a 30% drop in growth. (When I get a chance I will look at growth paths.)

What is more incredible, is that he counts the sixties as a period of inflation targeting, where unemployment held stable at 5 percent due to the stable inflation rate. What? The U.S. was targeting real GDP growth and unemployment, trying to exploit a long run Phillips Curve to raise the first and lower the second. The resulting increase in inflation becomes quite pronounced at the end of the period. This was one of the most serious macroeconomic disasters of the twentieth century.

Is this supposed to be a joke?