The Nominal GDP Debate Actually Matters

OK, this is going to be a little wonky (actually, a lot wonky):  Over the past several months there has been a debate in macroeconomic circles on whether the Federal Reserve should use target growth rates in nominal Gross Domestic Product (i.e., change in GDP without adjusting for inflation)to establish its monetary policy.  The thinking is that, since nominal GDP includes inflation, a nominal GDP growth target will enable the Fed to seek to stimulate economic growth, while still monitoring inflation.

The reasoning behind this is that if nominal GDP exceeds the target growth rate, the excess growth could be seen as inflationary.  But until growth reaches the target rate, the Fed should aggressively pursue and expansionist monetary policy.  Some proponents of this approach argue that such a policy would re-set expectations in the economy toward growth and therefore change behaviors so that growth would become more likely, further fueling those expectations and creating a “virtuous circle” in which the expectations of growth help fuel growth itself.

Supporters argue changing expectations was the key to Paul Volcker’s success at stopping inflation in the early 1980s.  Working in the opposite direction from a nominal GDP approach, the argument goes that he dramatically changed expectations about inflation and those changed expectations help curb inflation.  Over at the Economist, the Free Exchange blogger doesn’t buy this:

Mr Volcker’s policy did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand. As unemployment moved up the Phillips Curve, inflation plummeted. Only then did inflation expectations stabilize at a lower level. (Brad DeLong provides a neat chart on page 12 of these lecture notes showing the shift in the Phillips Curve after the Volcker disinflation.) The lesson of the Volcker disinflation is that changing expectations depends crucially on delivering on the target. Naming an inflation or money supply target is helpful, but insufficient unless the central bank demonstrates it is willing and able to achieve it.

So, a nominal GDP policy will only work if it can dramatically fuel economic growth.  Only then will expectations change.  The argument is that this could be difficult if the economy remains in or close to a liquidity trap.  Further, nominal GDP targets are tricky to manage in a down cycle like this one, but may get even more complicated to track once the economy really starts growing.  You can read the full argument here.  Yes, this is all very wonky.  But like Volcker’s decision in the 1980s, Ben Bernanke’s decision about this approach will affect our economy for a long time.

Stay tuned.

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