Nominal gdp targeting

What Is Nominal GDP Targeting?

Nominal GDP targeting is a monetary policy strategy where a central bank aims to stabilize the total nominal spending, or income, within an economy, as measured by Gross Domestic Product (GDP) not adjusted for inflation. This framework seeks to ensure a predictable path for the economy's aggregate nominal income, allowing for appropriate adjustments to monetary conditions to offset unexpected economic shocks. Unlike strategies that focus solely on inflation or unemployment, nominal GDP targeting explicitly considers both price changes and real economic growth in its objective.

History and Origin

The concept of nominal GDP targeting has roots in economic thought stretching back to the early 20th century with economists like Friedrich Hayek. However, it gained more formal academic advocacy in the late 1970s and early 1980s, notably from neo-Keynesian economists James Meade in 1977 and James Tobin in 1980.⁸ Their proposals emerged in a period when central banks were grappling with the challenges of high inflation and unstable money demand, seeking more credible monetary discipline. The idea lay dormant for several decades but experienced a resurgence in popularity following the 2008 global financial crisis. Economists, particularly those associated with "market monetarism" like Scott Sumner, argued that central banks' adherence to other frameworks contributed to the severity of the recession and that a nominal GDP target could have mitigated the downturn.⁷

Key Takeaways

• Nominal GDP targeting is a monetary policy framework aiming to stabilize the economy's total nominal spending or income.
• It inherently accommodates both demand and supply shocks, as it targets a nominal aggregate that reflects both output and prices.
• The strategy typically involves either targeting a specific growth rate of nominal GDP or a specific level path for nominal GDP, with the latter requiring "make-up" policy for past deviations.
• Proponents argue it provides greater macroeconomic stability, particularly during periods of significant business cycle fluctuations or when interest rates are near zero.
• Despite academic advocacy, no major central bank has formally adopted nominal GDP targeting as its primary framework.

Formula and Calculation

Nominal GDP targeting is a policy rule that guides the setting of interest rates or other monetary tools to achieve a desired path for nominal GDP, rather than a direct calculation of nominal GDP itself. The core idea is to define a target growth rate or a target level path for nominal GDP.

If a central bank sets a target growth rate for nominal GDP, say (g_{NGDP}), their objective is to ensure that the year-over-year percentage change in nominal GDP adheres to this rate.

If a central bank sets a target level path for nominal GDP, it establishes a specific trajectory for the absolute level of nominal GDP over time. For example, if the target is to grow nominal GDP at (X%) annually from a base level (NGDP_{base}), the target nominal GDP for year (t) would be:

$NGDP_{target,t} = NGDP_{base} \times (1 + X)^t$

Under a level targeting regime, if nominal GDP falls below its target path in one period, the central bank would then aim for higher-than-average nominal GDP growth in subsequent periods to "make up" for the shortfall and return to the original path. Conversely, if nominal GDP overshoots, policy would tighten to bring it back to the target level. This concept of "make-up" policy is a key distinction from growth rate targeting.

Interpreting Nominal GDP Targeting

Interpreting nominal GDP targeting involves understanding its implications for both real output and prices. Since nominal GDP is the product of real GDP and the price level, a stable nominal GDP growth target allows for flexibility in how that growth is split between real economic growth and inflation.

For instance, if a central bank targets a 5% annual growth in nominal GDP, and the economy experiences a positive supply shock (e.g., increased productivity), real GDP might grow by 3%, leading to an inflation rate of 2%. Conversely, if a negative supply shock occurs (e.g., an oil price increase), real GDP growth might slow to 1%, allowing inflation to rise to 4% while still hitting the 5% nominal GDP target. This flexibility contrasts with inflation targeting, where the central bank might have to tighten policy in response to a supply shock that pushes up prices, thereby exacerbating the downturn in real output. By focusing on nominal GDP, the policy implicitly permits temporary adjustments in inflation to cushion the impact of supply shocks on real activity and the output gap.

Hypothetical Example

Consider a hypothetical economy, "Diversiland," where the central bank adopts a nominal GDP level targeting strategy, aiming for a 4% annual growth path for nominal GDP from a base of $10 trillion in 2024.

• 2024 Target: $10 trillion
• 2025 Target: $10.4 trillion ($10 trillion * 1.04)
• 2026 Target: $10.816 trillion ($10.4 trillion * 1.04)

Now, imagine in 2025, a significant supply chain disruption occurs, causing slower real growth and higher inflation. Actual nominal GDP for 2025 comes in at $10.2 trillion, falling short of the $10.4 trillion target.

Under a nominal GDP level targeting regime, the central bank would not simply aim for 4% growth in 2026. Instead, it would implement a more accommodative monetary policy to "catch up" to the established path. For 2026, the central bank would aim for nominal GDP to reach $10.816 trillion. To achieve this from the actual 2025 level of $10.2 trillion, it would need nominal GDP to grow by approximately 5.06% ($10.816 / $10.2 - 1). This "make-up" approach aims to anchor long-run expectations about the path of total nominal spending and income, providing greater predictability than a simple growth rate target.

Practical Applications

While not widely adopted by major central banks, nominal GDP targeting is a recurring topic in discussions of optimal monetary policy frameworks. Its practical applications are primarily debated within academic and policymaking circles as a potential alternative to current regimes, such as flexible inflation targeting.

Proponents argue that nominal GDP targeting offers several advantages:

• Shock Absorption: It naturally accommodates both aggregate demand and aggregate supply shocks. If a negative supply shock reduces real output, allowing for higher inflation (to maintain the nominal GDP path) can prevent a deeper recession. Conversely, if a positive supply shock leads to faster real growth, it naturally allows for lower inflation.⁶
• Zero Lower Bound (ZLB) Mitigation: In periods where interest rates are at or near zero (the ZLB), conventional monetary policy tools like lowering interest rates become ineffective. A nominal GDP level target, by committing to "make up" for past shortfalls, can stimulate expectations of future nominal income growth, which can encourage current spending and investment even when rates are at the ZLB. This could reduce the need for unconventional measures like quantitative easing.
• Simplicity and Communication: Some argue that targeting total nominal income is simpler and more intuitive for the public to understand than targeting a specific inflation rate or managing complex economic indicators. Policy could be communicated as aiming for a steady growth in the nation's total income.

Despite these theoretical advantages, no major central bank currently implements nominal GDP targeting. The Federal Reserve has discussed it, and some of its principles (like responding to both output and price stability) are embedded in existing dual mandates. The Federal Reserve Bank of Richmond, for example, has published research examining the concept.⁵

Limitations and Criticisms

Despite its theoretical appeal, nominal GDP targeting faces several limitations and criticisms that have prevented its widespread adoption:

• Data Lags and Revisions: Real-time Gross Domestic Product data is subject to significant lags and frequent revisions. Policymakers would be making decisions based on potentially outdated or inaccurate information, which could lead to policy errors.⁴
• Communication Challenges: While some proponents argue it's simpler, critics contend that communicating a nominal GDP target to the public, particularly households and firms, could be challenging. The public is more familiar with concepts like inflation and unemployment than with aggregate nominal income, potentially undermining the credibility of the central bank's actions.³
• Lack of Direct Financial Stability Focus: A nominal GDP target does not inherently address issues of financial stability, such as asset bubbles or excessive credit growth. Critics argue that focusing solely on nominal spending might lead central banks to overlook growing risks in the financial system.²
• Supply-Side Considerations: While nominal GDP targeting accommodates supply shocks, some economists argue it might not always lead to optimal outcomes. For instance, if there's a permanent negative supply shock that reduces potential economic growth, maintaining a pre-determined nominal GDP path would necessitate higher and potentially persistent inflation, which might be undesirable for price stability.
• Uncertainty with "Make-Up" Policy: For nominal GDP level targeting, the "make-up" aspect introduces policy discretion and complexity. The optimal speed and method of making up for past deviations are not always clear, and persistent deviations could lead to large adjustments. Some research suggests that uncertainty about the future hampers economic performance more under nominal GDP level targeting compared to other policies like price level targeting.¹

Nominal GDP Targeting vs. Inflation Targeting

Nominal GDP targeting and inflation targeting are both frameworks for conducting monetary policy, but they differ in their primary objective and how they respond to economic shocks.

The core distinction lies in their response to supply shocks. Nominal GDP targeting allows the split between real growth and inflation to vary, absorbing the shock more smoothly for real activity. Inflation targeting, conversely, prioritizes keeping inflation within a narrow band, which can lead to greater volatility in real output in response to supply-side disturbances.

FAQs

What is the main goal of nominal GDP targeting?

The main goal of nominal GDP targeting is to stabilize the total amount of spending and income in an economy over time, typically by aiming for a steady growth path for Gross Domestic Product before adjusting for inflation. This helps to create a predictable environment for businesses and consumers.

How does nominal GDP targeting handle economic shocks?

Nominal GDP targeting is designed to handle both demand and supply shocks. If there's a negative demand shock, the central bank loosens monetary policy to boost spending. If there's a negative supply shock (like an oil price surge), it allows for a temporary increase in inflation to keep overall nominal spending on target, preventing a deeper downturn in real economic activity.

Has any country actually used nominal GDP targeting?

No major central bank has formally adopted nominal GDP targeting as its primary policy framework. While it has been widely discussed and researched by economists as a potential improvement over existing strategies, it has not been implemented in practice.

Is nominal GDP targeting better than inflation targeting?

Whether nominal GDP targeting is "better" than inflation targeting is a subject of ongoing debate among economists. Proponents argue it offers greater stability for real output during supply shocks and can be more effective at the zero lower bound for interest rates. Critics point to challenges with data accuracy, communication, and its lack of direct focus on financial stability or deflation control.