NGDP Targeting in Developing Countries

Scott Sumner commented on the article by Pranjul Bhandri and Jeffrey Frankel arguing that Nominal GDP targeting is relatively desirable for developing countries.    Scott disagreed and argued that it would be better to target labor compensation.   He may be correct that labor compensation is the better target, but his argument was faulty.

Scott wrote:

However I've also argued that NGDP targeting is not optimal when countries depend heavily on the production of commodities with very volatile prices. Suppose 50% of Kuwait's NGDP were oil production. If global oil prices doubled, and Kuwaiti oil output remained unchanged in physical terms, then the central bank of Kuwait would have to reduce non-oil production to zero in order to keep NGDP stable. Obviously that would not be optimal.

If Kuwait's GDP (real and nominal) was composed 50% oil production and 50% of other things, and the world price of oil doubles and the number of barrels of oil produced stays the same, and real GDP is held constant, then real GDP from all other activities must drop to zero.  I grant that would not be optimal.

But nominal GDP targeting doesn't require that real GDP remain constant.  The factor Scott ignores is the exchange rate between the Kuwati Dinar and other currencies.   Assuming that the global price of oil is quoted in dollars, the immediate effect of doubling of global oil prices would be a doubling of the dollar price of the Kuwati Dinar.   While the dollar price of oil will have doubled, the price of oil in Kuwati Dinar would be the same, and assuming, for the moment, no other change in Kuwati economic activity, nominal GDP for Kuwait in Dinars is unchanged.

Of course, this large increase in the exchange rate of the Kuwaiti Dinar is going to have major effects on the Kuwaiti economy.   Prices of imported goods in the shops will fall substantially.   The unchanged nominal incomes will now purchase twice as many imported goods.    All Kuwatis benefit from the favorable supply shock.

In a not unrealistic scenario for Kuwait, suppose all the other goods produced by the economy are nontraded.    Kuwait exports oil and operates shops that sell imported goods and have barbers who give haircuts.   Suppose that the nontraded goods are normal.  The Kuwaitis can now buy more foreign consumer goods.   They need and desire bigger and more expensive shops.  They also get more frequent and fancier haircuts.

The increased demand for nontraded goods would tend to raises their prices in Kuwaiti Dinar, and so raise nominal GDP.   This would require a  further appreciation of the Kuwati Dinar.    This reduces the value of the unchanged quantity of oil in Dinars, and so reduces nominal GDP.     The Dinar must rise enough so the Dinar value of oil produced in Kuwait falls enough to exactly offset the increase in demand and so expenditure on nontraded Kuwati goods.

Now, the reduced price of oil in Dinars should result in a lower quantity of oil supplied and so free up labor and other resources to shift over to production in the nontraded goods sector.   Former oil workers shift over to work in shops selling imported consumer goods or else be barbers.  

Of course, Scott's assumption that the the quantity of oil remains the same suggests a lower Dinar price of oil frees up no resources from the oil industry.   That is plausible enough.   It is all extraction of existing oil   The cost of the mechanics repairing the pumps and pipelines is trivial.    It is nearly all rent extraction.   Initially the Dinar rose enough that the nominal value of the rents were unchanged, but the income effect raising the demand for nontraded goods requires a further appreciation of oil so that the nominal rents from oil fall enough to keep total spending unchanged. Perhaps the Emir hires a few less soldiers and instead they go work in the shops and cut hair.   The remaining soldiers get more haircuts and go to fancier shops.   The barbers and shopkeepers also go to fancier shops and get more haircuts.   And everyone enjoys many more imported consumer goods.

However, let's suppose that some Kuwaitis are employed growing dates.   Perhaps they export dates.  Perhaps they solely sell dates domestically in competition with imported dates.   When the world price of oil doubles and the exchange value of the Kuwati Dinar doubles as well, the date growers are in trouble.   The prices they receive from exporting dates fall in half.   The price they can get for their dates from domestic retailers also fall in half.   

This would lead a collapse in Kuwait's domestic date industry.    The appreciation of the Kuwati Dinar would therefore need to be less than in the situation where oil is the only traded good.   Dinar expenditures on oil would rise, and Dinar expenditures on dates would fall.   This would be desirable to the degree it would create signals and incentives to shift resources away from date production to oil production.   Again, the assumption in Scott's scenario that the quantity of oil remains constant implies that no additional labor and other resources are needed in the oil industry.    Still, the lower prices of imported consumer goods increases real income, which increases demand in the nontraded goods sector as before.   For Kuwait, it is easy to imagine that the adverse impact of the change in world oil prices on the date industry would have no significant impact on the entire economy.

Of course, other developing economies might be different.   

Anyway, the problem Scott sees is not really that a developing country has a major product with a volatile price.   On the contrary, what nominal GDP targeting does is make the exchange rate and the prices of imported consumer goods adjust rather than wages and other nominal incomes.   The problem Scott really sees is where the product is one with an inelastic supply.    If expenditure on that product increases, there is little possibility of expanding its production by increasing the employment of resources.   Nominal GDP targeting requires that expenditure be reduced elsewhere in the economy to offset the increase.  The signal and incentive to contract output and employment in the rest of the economy to free up resources to expand the product where expenditure increased is inappropriate because it is difficult or impossible in the sector with increased expenditure.  

So, if there is some developing economy where a large portion of its output is oil, copper, diamonds, or gold, and it has substantial output of other traded goods, perhaps local farmers compete with imported grain, then shifts in the world demand for the good with inelastic supply will impact the exchange rate, spending in export and import competing industries.   Spending on the product with inelastic supply will change in terms of the domestic currency, requiring offsetting changes in spending in the rest of the economy.