Tuesday, October 25, 2011

McCallum and Targeting the Growth Rate of Nominal GDP

Bennett McCallum has written a short article showing his continued support for targeting nominal GDP. It was especially good to see it published by the Shadow Open Market Committee, a traditional outlet for "old monetarism."

McCallum describes some benefits for nominal GDP targeting, but comes down in favor of targeting the growth rate rather than the growth path. He does note that this view is controversial among advocates of the NGDP target. I must admit that in some ways I feel more kinship with advocates of price level targeting than with advocates of targeting the growth rate of nominal GDP!

McCallum explains that targeting the growth rate of nominal GDP can result in level drift. However, as long as the shocks to nominal GDP growth are symmetrical, then this shouldn't be much of a problem.

The disadvantage to targeting the growth path of nominal GDP is that if growth rises too fast, then a contractionary monetary policy must shift it back down to the target. The assumption is that the monetary authority would be creating an additional disturbance, causing a mild, or maybe severe, recession.

Oddly enough, McCallum didn't speak of the reverse situation, where nominal GDP falls below its trend growth path. Is it the case that the monetary authority would be creating an additional disturbance to force nominal GDP back to its trend growth path?

It is exactly this scenario that has made me adamantly in favor of targeting the growth path. Admittedly, the Fed isn't really targeting nominal GDP growth, but the growth rate since the recovery began hasn't been bad. It is slightly above 4 percent, almost exactly the growth rate proposed by the economists at Goldman-Sachs. Presumably, it is equal to an estimated 2.5 percent growth rate for potential output and a 2 percent trend inflation rate. The problem with the current growth path is that it is way too low. Rather than a sharp "V-shaped" recovery, we are languishing with a large output gap and an unemployment rate well above the natural unemployment rate.

More importantly, growth path targeting creates expectations that generate market forces that tend to keep nominal GDP on target. (Of course, on the target growth path, the target growth rate implies remaining on the target growth path.) If the economy appears to be slowing, and nominal GDP is likely to be below target, then sales will be expected to growth extra fast in the subsequent period. This reduces (or hopefully, prevents) positive feedback loops where reduced current growth in real output results in greater saving, reduced investment, or, more fundamentally, additional money demand, so that future nominal growth is also reduced.

Considering prices, to the degree reduced nominal growth results in disinflation (and deflation if the trend inflation rate is very low, say zero or even slightly negative already,) then the reduction in the price level will be expected to be reversed. Current deflation results in expected inflation. This prevents the disastrous positive feedback loop where current deflation creates expectations of future deflation, increased money demand and reduced nominal expenditure and so more deflation. Instead, if the price level falls, it is now low relative to its expected future value, and so motivates an increase in spending now.

To the degree prices are sticky, then prices hardly drop at all. However, reversing the decrease in nominal GDP means that prices can return to equilibrium without needing further disinflation to adjust to the new, lower growth path of nominal GDP. With GDP targeting, (rather than final sales targeting,) future final sales rise in response to an inventory buildup, which provides an incentive to maintain production even in the face of slower sales.

The same stabilizing market forces apply when nominal GDP grows too fast. With nominal expenditure targeting, if the economy appears to be overheating, the expectation will be that it will slow.

Again, looking at prices, if more rapid growth in spending results in higher prices, then their future growth will be slower. If the trend inflation rate is zero, the effect is obvious. Prices rise now, but will be expected to fall. Current prices are exceptionally high, and there is an incentive to refrain from making purchases now, slowing the economy. (With a trend inflation rate, the effect can be better described using nominal and real interest rates. Any given nominal interest rate implies an higher real interest rate if inflation is expected to slow.)

What is the disadvantage? If we imagine an upward shock to the price level, that is not associated with a decrease in potential output, then nominal GDP rises. Targeting the growth path of nominal GDP requires that somehow an excess demand for money develop, forcing a reduced flow of spending, so that prices are forced back down. Targeting the growth rate of nominal GDP, on the other hand, would accommodate this increase in the price level, and allow the flow of money expenditures to grow at the target rate from that point on.

Suppose that instead we imagine a downward shock to potential output, and there is no associated increase in prices. This reduces nominal GDP. Targeting the growth path of nominal GDP would require that an excess supply of money be generated, forcing an increased flow of expenditure, so that prices are forced up. Targeting the growth rate of nominal GDP, on the other hand, would accommodate this decrease in potential output, and allow the flow of money expenditures to grow at the target rate from that point on.

On the other hand, suppose that adverse aggregate supply shocks involve a decrease in supply in some particular market. For example, a drought hits the Iowa corn crop. The decrease in supply of corn raises the price of corn and reduces the quantity of corn. As a matter of arithmetic, the price level rises and real GDP falls. The impact on nominal GDP is ambiguous.

More exactly, as George Selgin has explained, the immediate impact depends on the elasticity of demand for corn. If the demand for corn is unit elastic, then expenditures on corn remain the same and expenditure on everything else also remains the same. If the demand for corn were inelastic, then total expenditure on corn rises, and the demand for everything else falls. And if the demand for corn is elastic, then the expenditure on corn falls, and spending on everything else rises.

Of course, since it is the future level of nominal GDP that is actually targeted, then unexpected supply shocks push nominal GDP away from target. If they are temporary, then they don't effect future nominal GDP. Further, there is no need for monetary disequilibrium to force nominal GDP back to its target growth path. If the corn harvest recovers next year, then the price of corn falls and the quantity of corn rises.

Further, supply shocks expected to persist, or more generally, expected future supply shocks, have impacts that are at least qualitatively appropriate regarding resource allocation. For example, suppose the United Auto Workers gets very militant and demands pay hikes. Their employers acquiesce and raise prices and reduce production. If car demand is inelastic and this problem is likely to persist, total expenditures on cars rise, and spending in the rest of the economy falls. This reduction in demand tends to free up resources to produce other things. But what other things? Perhaps to produce more cars in nonunion shops in South Carolina. Perhaps to produce more export goods to exchange for imported cars. Of course, this is about the long run elasticity of supply of cars. It is certainly likely that slow growth in real incomes for everyone else in the economy would be at least part of the impact of the militant unions. Targeting the growth path of nominal GDP would require slower growth in nominal incomes in the rest of the economy.

If, on the other hand, the demand for cars were elastic, then total spending on cars would fall, and expenditure in the rest of the economy would rise. The demand for other goods would rise, requiring more resources. Where could those resources come from? Perhaps from those who would have been hired by the car companies if the unions were less militant.

It is at about this point where I just go with--a stable growth path of nominal expenditure is the least bad environment for microeconomic coordination. However, there is a bit more to say regarding the distinction between targeting the growth rate or growth path of nominal GDP. Expected future supply shocks to goods whose demands are not unit elastic has the exact same potentially undesirable effect whether the growth rate or growth path of nominal GDP is targeted.

So, it comes down to persistent unexpected supply shocks for goods with other than unit elastic demands freeing up too many resources or demanding too many in the rest of the economy, versus the ability of the economy to better avoid undesirable shifts in aggregate expenditures and to rapidly recover from any adverse effects.

The last three years has convinced me that avoiding and rapidly reversing changes in nominal expenditures--especially decreases--is very important.


  1. Bill,

    This is really good. You should turn this into a note--maybe with some illustrations--and submit it to the CATO Journal or some other policy-type journal.

  2. Bill
    I agree with DB. Now that, with Krugman, DeLong and GS stating support, it is best that all the "confusion" that´s been surfacing in a host of posts and comments be addressed in a consistent way.

  3. It will be really interesting to see when the growth will come, so we just need to play it safe and don’t do anything silly or silly it could create huge problems for us. I always keep I straight forward and it’s not too tough either with broker like OctaFX which is awesome having wonderful features like small spread, zero balance protection, swap free account and even mighty bonus up to 50%, it’s all so useful and helps with working.