NGDP Level Targeting Responds Correctly To Supply Shocks

A blog about business and economics.
March 27 2012 9:22 PM

NGDP Level Targeting Responds Correctly To Supply Shocks

Apropos of nothing in particular, it strikes me that as the idea that central banks should ditch inflation rate targeting in favor of nominal gross domestic product level targeting some people have got it into their heads that this is just a clever emergency proposal to deal with the present circumstances of mass unemployment. I do think that adopting a reasonable NGDP level target would help deal with today's problems, but it's a policy that I would recommend as superior to inflation targeting all the time. Immunity to the "zero lower bound" problem is one reason, but the more important reason is that an NGDP targeting central bank would respond better to supply shocks than would an inflation targeting central bank.

Consider, for example, the possibility that a terrorist attack in Kuwait disrupts world oil supplies. This is going to contract aggregate demand in the United States because as oil gets suddenly more expensive, the dollar value of our imports from non-disrupted countries will soar but those countries aren't going to immediately start importing more foreign goods in response. But the more expensive oil is also going to push the price level way up. Inflation targeting tempts the central bank to respond to this surge in inflation with tighter money even as the economy is being rocked by a fall in demand. An NGDP targeting central bank, by contrast, is able to say "steady as she goes." For the duration of the negative supply shock the country will experience an unusually large amount of inlation and an unusually small amount of real growth, which will suck, but the suckiness won't be compounded by tight money regime. Conversely, an NGDP targeting central bank will simply take a positive supply shock as welcome news. Real growth rises and inflation falls leading to a nice pleasant span of unusually rapid real wage growth. Everyone applauds. An inflation targeting central bank, by contrast, is going to greet the good news with a weird kind of panic as if improved technology or a natural resource boom is some kind of deflationary crisis.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.