Why Central Banks Ought to be Targeting Nominal GDP Over Inflation

Currently central banks of all major economies are using an inflation targeting strategy to ensure macro-economic stability through changes in the money supply: Bank of England, European Central Bank, Federal Reserve and Bank of Japan amongst many others. To understand why NGDP targeting will likely fare better in providing stability we must understand what it is. NGDP can be defined as the total output of an economy using current (nominal) prices or, to look at it from the opposite perspective, the total expenditure in an economy using nominal prices. So, NGDP targeting can be translated into targeting the total amount of nominal spending in an economy. Inflation on the other hand can simply defined as the rate of change in price level.

As NGDP is a measure that combines both price level and real output into one so it can be said that an increase in NGDP can be caused by: an increase in price level (inflation) or actual economic growth. Therefore, economic growth that is higher than usual will lead to the central bank targeting lower inflation and a slump in economic growth will lead to banks targeting increased inflation. As said earlier, the bank is trying to keep the rate of growth in nominal spending stable and constant through counteracting unfavourable changes in real output using inflation.

Why is it important we target total spending in an economy over inflation? The answer is that nominal spending in an economy is far more important than inflation on its own. It is important because on the whole firms set employees’ wages in nominal terms and not real terms (meaning firms don’t automatically adjust wages with inflation, they instead remain constant). So a drop in nominal spending will mean that firms won’t have enough money to pay workers there (nominal) wages. This is due to firms having less money from decreased nominal expenditure to meet wage demand that has remained constant.

There is a mismatch in what consumers are spending and what firms are expected to pay their workers. Firms must respond by either cutting wages or sacking workers but history has shown that this is much likely to result in the latter due to the so called “sticky wages” phenomenon (see: Why wages do not fall in recessions for more information why). So, it can be concluded that a drop in nominal spending (NGDP) will most likely cause an increase in unemployment.

NGDP targeting can help stabilize and reduce the effects of changes in output brought about by the business cycle. During times of economic downturn higher inflation targeting by the central bank can offset poor output performance to ensure nominal spending stability. When the opposite occurs and an economy is over heated (real output is above potential output) high inflationary pressure is often a result. Real output will be increasing at a faster rate (above the trend rate) during such times therefore the central bank will target decreased inflation through contractionary monetary policy.

There are also scenarios were central bank’s mandates to follow low inflation targets have resulted in poor nominal spending growth. The European central bank is the most prominent of examples having described their own definition of price stability as “Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%”. The ECB has been consistently fighting inflation which has resulted in all-time high unemployment in weaker European economies such as Italy.

Italy's Unemployment Rate
Source: The Economist

NGDP targeting by central banks would result in greater macroeconomic stability due to its ability to react to and minimize the effects of unfavourable output levels. The concept of NGDP targeting is one that has been gaining momentum amongst economists due to publicity by writers at: The Adam Smith Institute, Market Monetarist, Macro and Other Market Musings and The Economist to name a few. It has also been favoured by Goldman Sachs economists. To this end I must credit all those mentioned for the creation of this article. In summary, I strongly believe the idea is gaining  popularity due to the logic and strong reasoning behind it as well as a belief it will outperform current policies of inflation targeting in achieving increased macroeconomic stability.