I meant to do so weeks ago, but I only just got around to reading the little flurry of posts concerning NGDP targeting that was set off by John Taylor’s critical remarks on the topic. And now, despite the delay, I can’t resist putting-in my own two cents, because it seems to me that much of the discussion misses the real point of targeting nominal spending, either entirely or in part; what’s more, some of the discussion is just-plain nonsense.
Thus Professor Taylor complains that, “if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting.” Now, first of all, while it is apparently sound “Economics One” to begin a chain of reasoning by imagining an “inflation shock,” it is crappy Economics 101 (or pick your own preferred intro class number), because a (positive) P or inflation “shock” must itself be the consequence of an underlying “shock” to either the demand for or the supply of goods. The implications of the “inflation shock” will differ, moreover, according to its underlying cause. If an adverse supply shock is to blame, then the positive “inflation shock” has as its counterpart a negative output shock. If, on the other hand, the “inflation shock” is caused by an increase in aggregate demand, then it will tend to involve an increase in real output. Try it by sketching AS and AD schedules on a paper napkin, and you will see what I mean.
Good. Now ask yourself, in light of the possibilities displayed on the napkin, what sense can we make of Taylor’s complaint? The answer is, no sense at all, for if the “inflation shock” is really an adverse supply shock, then there’s no reason to assume that it involves any change in NGDP. On the contrary: if you are inclined, as I am (and as Scott Sumner seems to be also) to draw your AD curve as a rectangular hyperbola, representing a particular level of Py (call it, if you are a stickler, a “Hicks-compensated” AD schedule), it follows logically that an exogenous AS shift by itself entails no change at all in Py, and hence no departure of Py from its targeted level. In this case, although real GDP must in fact decline “much more than with inflation targetting,” that is only because strict inflation targeting in the face of an adverse supply shock can mean luring the economy upwards along a sloping short-run AS schedule, that is, forcing real GDP temporarily above its long-run or natural rate–something, I strongly suspect, Professor Taylor would not wish to do.
If, on the other hand, “inflation shock” is intended to refer to the consequence of a positive shock to aggregate demand, then the “shock” can only happen because the central bank has departed from its NGDP target. Obviously this possibility can’t be regarded as an argument against having such a target in the first place! (Alternatively, if it could be so regarded, one could with equal justice complain that similar “inflation shocks” would serve equally to undermine inflation targeting itself.)…