What if the Fed had taken NGDP targeting seriously?

Targeting the level of nominal GDP (the total number of dollars spent/earned in a year) has become the fad of the year, partly because it is a strong argument in favor of further Fed stimulus. Paul Krugman, Goldman Sachs, and The Economist have all said nice things about it. A professor at Bentley University seems to have dedicated the past few years of his life to it.

Of course, the idea is not new. Far from it—nominal income targeting actually goes back to the 1970s. Over subsequent years it got attention from several big-name economists including Martin Feldstein, Greg Mankiw, Robert Gordon, John Taylor and Robert Hall. It was even championed by my favorite Fed governor of the 1990s: Larry Lindsey.

The point of this post is not to review the literature or consider why nominal income targeting was not adopted earlier. I also do not want to return to the question of whether monetary stimulus alone is capable of healing the economy. Rather, I want to see what the Fed would have done in the years before the big slump if it had carefully targeted nominal income. The answer might surprise you.

The premise behind NGDP targeting is that NGDP ought to grow at a constant rate once it is at some optimum level. The objective for the monetary authority is to keep actual NGDP as close as possible to this theoretical “optimum.” To do this, the central bank needs to answer three questions:

  • Where is the economy relative to its sweet spot?
  • What is the desired growth rate once you reach the sweet spot?
  • How does the monetary authority push nominal spending toward its desired path?

The first question is pretty subjective. However, I think we can come up with some rough answers. I think that in 1995 the U.S. economy was in the sweet spot. “Potential” GDP (admittedly a flawed concept) agrees with me:

What about the growth rate once you return to the “optimal” path? This is also subjective. Hayek thought that an NGDP growth rate of 0% (per capita) would be ideal. The current consensus is for 5%, however, so I will use that.

The third question is the big one. No one really knows the answer. It is the elephant in the Fed boardroom. Fortunately, we do not need to have any confidence in the capabilities or competence of the monetary authority to go through this intellectual exercise.

So, what do we get if we assume 1995 was a good year and then compare actual nominal GDP with the theoretically “optimal” path generated by adding 5% a year to the nominal GDP recorded in 1995?


Contemporary advocates of NGDP-targeting focus on the enormous shortfall of the past few years. Few of them even mention the excesses that preceded the recent bust. If they were serious about their ideas, they would point to what can only be described as the irresponsible looseness of Fed policy (under their framework) in the second half of the 1990s and the middle of the 2000s.

Claiming that the Fed was too easy throughout that period makes a lot of sense. If the path of nominal income had been more restrained, the private sector would have been less eager to borrow. Perhaps the current account deficit would not have become so large and destructive. Perhaps we could have avoided the debilitating booms and busts that have defined the past 15 years. It all sounds far more preferable to what actually happened.

Of course, other people might look at these data and wonder whether it makes sense to target the level of nominal spending at all. Supposedly we returned to the “optimum” at the end of 2008. Most people do not remember that as a benign macro environment. Moreover, after falling towards this “optimum” level, the decline in NGDP accelerated and then overshot to the downside. Could that have been prevented? If not, how is the monetary authority ever supposed to bend the NGDP path towards its desired target?

No matter what you conclude, I hope you found this little exercise helpful for understanding the debate as it unfolds.


About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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