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.
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| 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.
