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Market Monetarism Maybe? The Case for Nominal GDP Targeting in Australia


Benjamin Thompson

By

August 16th, 2020


It’s time to move on from inflation targeting, a rules-based approach to monetary policy that stabilises nominal income growth can ensure financial stability and economic prosperity for the Australian economy.


The primary objective of the Reserve Bank of Australia (RBA) is to control inflation and to maintain a change in the consumer price index [1] of 2 to 3 per cent, on average, over time, in order to maintain price stability and achieve full employment. [2] However, given the recent news of deflation and of forecasted inflation being under 2 per cent in the next year [3], sooner or later Australia is going to need to take a new approach to monetary policy that can pull us out of the zero lower bound (ZLB) and help boost aggregate demand. Given the circumstances, it’s time for us to adopt a framework of nominal GDP targeting.

Changes in the Consumer Price Index (2010 – 2020) [7]

So, what is nominal GDP targeting? To start, we can think of nominal GDP as the sum of all spending in the economy, which would mean, if the RBA was going to target nominal GDP, it would stop targeting changes in the consumer price index and try to target the amount of nominal spending in the Australian economy. [4] In theory, the RBA would increase inflation when growth was lower than normal and reduce inflation if growth was higher than usual. Hence, targeting nominal GDP acts as a nominal anchor which keeps the growth rate of prices, wages and other activities denominated in dollars stable in order to prevent them from rapidly rising [5]. In practice, nominal income targeting would act as a flexible rule which would require the RBA to make up for any under- or overshoots of the target.

Nominal GDP Targeting Pathway [5, Fig. 2]

One of the strongest benefits of nominal GDP targeting is that it allows the central bank the flexibility to see through both positive and negative supply shocks, permanent or temporary, without the confusion of having to tell it apart from a demand shock, whether or not it is wrong, unlike inflation targeting. [6] For instance, let’s compare a 2 per cent inflation target to a target of 4 per cent growth in nominal GDP. To begin, we are in an economy with 2 per cent inflation and 2 per cent real GDP growth, and suddenly there’s a negative supply shock (e.g. a rise in oil prices) which drives inflation up to 3 per cent. Now the inflation-targeting central bank could let inflation bygones be bygones but let’s say it’s unable to tell the difference in real-time between a demand and supply shock (e.g. the early 1990s recession in Australia) and it aims to reduce inflation by raising the cash rate, this would cause real GDP growth to fall further and make the contraction worse than it had to be. On the other hand, a central bank targeting the growth rate of nominal GDP would not have this problem, it wouldn’t need to differentiate between a supply or demand shock as it would already be on the path to hit its target of four per cent nominal GDP growth, hence it would be able to see through a negative supply shock, even if it was wrong.

Nominal GDP Targeting and Negative Supply Shocks [5, Tab. 2]

Moving onward, not only is nominal GDP targeting a flexible rule, but it also helps to provide financial stability in a world of incomplete financial markets through its ability to create countercyclical inflation. For instance, let’s say again there’s a target of 4 per cent growth in nominal GDP, suppose real GDP falls by 1 per cent, and given the framework of NGDP targeting, inflation would rise to 3 per cent, in order to make up for the loss of output. [8] This puts the burden on creditors for misallocating capital by reducing the real value of the payments made by debtors, in other words, inflation is another way for debtors to default without consequence. On the other hand, if there’s a positive supply shock which causes real GDP to increase by 3 per cent and inflation to fall by one per cent, creditors reap the benefits of their investments by receiving more in payments as the real value of money goes up. This is what we call creditor-debtor justice, which makes fixed-price nominal loans act more like equity rather than debt, as creditors basically have a share of ownership in the economy and reap dividends in the form of higher growth if their investments are successful. [9]

And finally, not only does nominal GDP targeting provide flexibility while also ensuring financial stability, it’s an effective tool to prevent economies from entering the ZLB but also escaping it. First of all, in the case of falling output and real interest rates, like in COVID-19, expectations of inflation will rise higher and faster alongside the fall in output, as households and firms know that a credible central bank will do what it takes to hit its nominal GDP target, in contrast to the RBA’s current target of 2 to 3 per cent inflation, expectations will be anchored to the upper bound of 3 per cent and inflation will not be able to rise as fast as the fall in output. [10] Secondly, if the central bank is credible, then the public will understand that the amount of money being spent in the economy will keep growing and they will have less of an incentive to cut back on spending before-hand, hence, avoiding the ZLB from the beginning. [5]

Overall, nominal GDP targeting provides a framework for the RBA that allows it to see through supply shocks without the concern of being wrong, gives way for financial stability in a world of imperfect financial markets and is an effective anti-ZLB tool. It would be wise for the RBA to reconsider their inflation-targeting framework and move towards an approach to monetary policy to stabilise the level of spending in the economy.

• References

[1] “Inflation and its Measurement | Explainer | Education”, Reserve Bank of Australia. [Online]. Available: https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html.

[2] “What is Monetary Policy? | Explainer | Education”, Reserve Bank of Australia. [Online]. Available: https://www.rba.gov.au/education/resources/explainers/what-is-monetary-policy.html.

[3] P. Lowe Governor, “Opening Statement to the House of Representatives Standing Committee on Economics | Speeches”, Reserve Bank of Australia, 2020. [Online]. Available: https://www.rba.gov.au/speeches/2020/sp-gov-2020-08-14.html.

[4] S. Bowman, “Nominal GDP targeting for dummies — Adam Smith Institute”, Adam Smith Institute, 2014. [Online]. Available: https://www.adamsmith.org/blog/money-banking/nominal-gdp-targeting-for-dummies.

[5] D. Beckworth, “Facts, Fears, and Functionality of NGDP Level Targeting: A Guide to a Popular Framework for Monetary Policy”, 2020. [Online]. Available: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3463427.

[6] S. Sumner, “The Case for Nominal GDP Targeting”, Mercatus.org, 2012. [Online]. Available: https://www.mercatus.org/system/files/Sumner-NGDP-Targeting-sum-v1.pdf.

[7] “Measures of Consumer Price Inflation”, Reserve Bank of Australia. [Online]. Available: https://www.rba.gov.au/inflation/measures-cpi.html.

[8] S. Sumner, “The case for NGDP targeting – lessons from the Great Recession — Adam Smith Institute”, Adam Smith Institute, 2011. [Online]. Available: https://www.adamsmith.org/blog/tax-spending/the-case-for-ngdp-targeting-lessons-from-the-great-recession.

[9] G. Selgin, “Price-Level Movements, Fixed Nominal Contracts, and Debtor-Creditor Equity”, Cato Institute, 2018. [Online]. Available: https://www.cato.org/blog/price-level-movements-fixed-nominal-contracts-debtor-creditor-equity.

[10] W. McKibbin and A. Panton, “Twenty-five years of inflation targeting in Australia: Are there better alternatives for the next 25 years?”, rba.gov.au, 2018. [Online]. Available: https://www.rba.gov.au/publications/confs/2018/pdf/rba-conference-volume-2018-mckibbin-panton.pdf.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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