Nominal GDP Targeting: A Simple Rule to Improve Fed Performance

The history of central banking is a story of one failure after another. This record does not mean that our actual monetary regimes have been the worst of all possible regimes--far from it. But it does mean that we can improve policy by learning from experience. Every proposed reform is a response to a previous failure, an implicit display of lessons learned. A big part of this story has been the search for a robust monetary system that could produce good outcomes under a wide variety of conditions, without having to rely on a central bank run by a benevolent and omniscient philosopher king. It is a search for a monetary rule that can provide the appropriate amount of liquidity to the economy, under widely differing conditions. In this article, I argue that the optimal monetary rule is a nominal GDP (NGDP) target, or something closely related. To understand the advantages of this approach, it helps to see how the theory and practice of central banking have changed over time--that is, to see what went wrong with some previous monetary regimes, and how past reformers responded to those failures. The Gold Standard It is not hard to see why gold and silver were used as money for much of human history. They are scarce, easy to make into coins, and hold their value over time. Even today one finds many advocates of returning to the gold standard, especially among libertarians. At the same time most academic economists, Keynesian and monetarist, have insisted we can do better by reforming existing fiat standards. It is easy to understand this debate if we start with the identity that the (real) value of money is the inverse of the price level. Of course, in nominal terms a dollar is always worth a dollar, but in real terms the value or purchasing power of a dollar falls in half each time the cost of living doubles. During the period since we left the gold standard in 1933 the price level has gone up nearly 18-fold; a dollar today has less purchasing power than six cents back in 1933. That sort of currency depreciation is almost impossible under a gold standard regime; indeed the cost of living in 1933 wasn't much different from what it was in the late 1700s. This long-run stability of the price level is the most powerful argument in favor of the gold standard. The argument against gold is also based on changes in the value of money, albeit in this case short-term changes. Since the price level is inversely related to the value of money, changes in the supply or demand for gold caused the price level to fluctuate in the short run when gold was used as money. Although the long-run trend in prices under a gold standard is roughly flat, the historical gold standard was marred by periods of inflation and deflation. (1) Most people agree on that basic set of facts, but then things get more contentious. Critics of the gold standard like Ben Bernanke point to periods of deflation such as 1893-96, 1920-21, and 1929-33, which were associated with falling output and rising unemployment. This is partly because wages are sticky in the short run (see Bernanke and Carey 1996; Christiano, Eichenbaum, and Evans 2005). Supporters point out that the U.S. economy grew robustly during the last third of the 19th century, despite frequent deflation and a flawed banking system that was susceptible to periodic crises. They note wages and prices adjusted swiftly to the 1921 deflation, allowing a quick recovery. Countries with more stable banking systems, such as Canada, did even better. The big bone of contention is whether the Great Depression should be blamed on the gold standard or meddlesome government policies (see Cole and Ohanian 2004). My own research suggests the answer is both (see Silver and Sumner 1995). I do see some weaknesses in the arguments put forth by advocates of the gold standard. It is true that some of the worst outcomes were accompanied by unfortunate government intervention, particularly during the 1930s (see Cassel 1936 and Hawtrey 1947). …

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