How is NGDP targeting different from inflation targeting?

This is basically a note to myself, but may be of interest to some of you. I have been thinking lately about nominal GDP targeting. The idea in itself is old, but it has received a lot of attention in the blogosphere post 2009. I want to know under which conditions NGDP targeting produces different results than an inflation targeting regime.

So, to get a first intuition about this, I took the standard ASAD model from the shelf. I transformed everything into growth rates or, if you want to look at it differently, into deviations from the steady state equilibrium. Then I plugged in simple characterizations of the two different policy regimes. And the result is this: A minimalist ASAD analysis of NGDP targeting.

The basic insight is that NGDP targeting requires that any shock to aggregate demand (positive or negative) be completely offset by monetary policy while supply side shocks be neglected. In other words, NGDP targeting fixes the position of the AD curve and doesn’t worry about the position of the AS curve. Inflation targeting, on the other hand, demands that monetary policy takes into account both AD and AS shocks. As my little modelling exercise shows, there is a tight correspondence between the two regimes in the sense that for every given NGDP target there is an inflation target that produces the exact same path of real output and inflation as the NGDP target, and vice versa. I also show that if there were no supply side shocks, only demand shocks, the two regimes are equivalent. The difference between the regimes lies only in how they react to AS shocks: an inflation target tends to amplify the effects of AS shocks on output, the NGDP target doesn’t. Hence NGDP targeting tends to produce smaller fluctuations in real output growth than an inflation target.

So, if you believe macroeconomic shocks are mainly due to aggregate demand, you should be indifferent between the two regimes.

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Some More on Targets and Inequality

Caution: wandering mind and thoughts in process of clarification.

After reading through Max’s useful feedback in the comment section to my post on the possible effects on inequality of raising the inflation target I was forced to rethink the whole issue somewhat. First of all let me start by saying that, in the bigger scheme of things, the effects of raising the target inflation rate by 2% on inequality are indeed likely to be small, so how much this even matters is a question of debate in and of itself, but I hate to leave loose ends untied. To recap a bit, clearly there is a big difference between expected inflation and unexpected inflation. A central bank increasing its target inflation rate would have the effect of moving the value at which inflation expectations are anchored.

Yet even if fully expected this would have real effects due to what is generally known as the Mundell-Tobin effect – essentially the fact that, due to cash always paying 0% nominal interests, portfolio choices would change. More precisely, people would want to move away from cash and into bonds (or whatever you want to call the financial product used in your model). This move into bonds would raise the prices of bonds while lowering their yields, and it is this switch in portfolio compositions that would also cause the real interest rate in the economy to fall compared to where it was before. It would also change the distribution of income and wealth through various channels. As an example, it might be possible that there are constant entry costs when it comes to entering the bond market. Clearly this would mean that poorer households would be less able to protect themselves from the higher inflation rate as participating in the bond market would involve decreasing average costs, thus increasing inequality. At the same time the literature on the topic generally assumes that poorer households are net-debtors in the economy, and lower real interest rates would mean lower real interest payments, reducing inequality. In short, it seems to be anyone’s guess which effects dominate. Inflation is also generally referred to as a regressive tax on cash holdings, which would again drive up inequality somewhat.

But enough of that: to the main point of the post: from a perspective regarding the most direct effects on inequality, is a higher inflation target or a higher NGDP target preferable? Clearly my first post implied that I consider the answer to be the latter. I am not so sure anymore. As Max correctly pointed out, the change in inflation rate (a one-off effect) affects inequality, but within the moderate levels of inflation we’re talking about, there seems to be no reason to assume that inequality would be meaningfully affected beyond this initial movement. The big difference now between a higher inflation target and an NGDP growth or growing level target would be the degree to which inflation changes over time. Ideally, in the first case it would not change at all, while in the second case inflation would fluctuate as RGDP fluctuates.

Essentially it would seem RGDP, for different reasons including exogenous shocks, would fluctuate under both targets. The main advantage of an NDGP target would be to reduce this fluctuations since, much like the Taylor rule, it includes both output and inflation, while a strict inflation target (like the one of the ECB) does not. Clearly, however, the variance of inflation would, if the central bank does its job, be bigger under an NGDP target. That’s pretty much the feature of it. But, and in line with the thoughts outlined above, this would also mean that constant (essentially central bank-induced changes) in the inflation rate would, even if fully expected, also lead to constant (therefore also essentially central bank-induced) changes in real interest rates. Again, of course this is part of the idea – if RGDP falls, inflation would rise to meet the NGDP target, and real interest rates would fall (not only all other things equal but despite all other things adjusting), which would boost the economy causing RGDP to rise again – the whole point of the exercise.

Now, the general assumption is that variance in RGDP is bad for welfare – we would much rather have a constant real growth rate of, say, 2% per year than growth that is all over the place yet, over a certain period of time, averages 2% as well. Yet what does variance in RGDP do to inequality? I honestly would not know. In general, people with lower qualifications (i.e. on the lower end of the income spectrum) would get fired first in a downturn, but then again they also get hired first in an upturn. Is this process symmetric? That would seem to depend on the costs of hiring and firing people. If they are similar, the process would probably be symmetric, and the impact on inequality unimportant on average. But it would not seem farfetched to argue that, due to e.g. transaction costs and other market imperfections, variance in Inflation hurts the poor more than the rich. Again, if the technology for “inflation protection” (i.e. switching from cash to bonds) has decreasing average costs, as is likely, every switch would be more costly for poorer households than for richer ones. In short, the costs of protecting against inflation, which arise particularly when inflation changes, seem to be higher the poorer you are. So on these isolated grounds, a higher inflation target may be more desirable from a strict inequality standpoint.

Again, probably fairly trivial and not even I’m sure this really matters, but just sayin’.