Nominal GDP Targeting and the Taylor Rule on an Even Playing Field

• Published date: 01 February 2020
• Author: DAVID BECKWORTH,JOSHUA R. HENDRICKSON
• Date: 01 February 2020
• DOI: http://doi.org/10.1111/jmcb.12602

DOI: 10.1111/jmcb.12602

DAVID BECKWORTH

JOSHUA R. HENDRICKSON

Nominal GDP Targeting and the Taylor Rule on an

Even Playing Field

Some economists advocate nominal GDP targeting as an alternative to the

Taylor Rule. These arguments are largely based on the idea that nominal

GDP targeting would require less knowledge on the part of policymakers

than a traditional Taylor Rule. In particular, a nominal GDP targeting rule

would not require real-time knowledge of the output gap. We examine the

importance of this claim by amending a standard New Keynesian model to

assume that the central bank has imperfect information about the output gap

and therefore must forecast the output gap based on previous information.

Forecast errors by the central bank can then potentially induce unanticipated

changes in the short-term nominal interest rate, distinct from a standard

monetary policy shock. We show that forecast errors of the output gap by

the Federal Reserve can account for up to 13% of the fluctuations in the

output gap. In addition, our simulations imply that a nominal GDP targeting

rule would produce lower volatility in both inflation and the output gap in

comparison with the Taylor Rule under imperfect information.

JEL codes: E52

Keywords: nominal GDP targeting, imperfect information, monetary

policy.

SOME ECONOMISTS ADVOCATE NOMINAL GDP targeting (Sumner

2011, 2012; Hendrickson 2012a) as an alternative to the Taylor Rule. In short, the

argument for a nominal GDP target is that it allows central bankers to focus on

one variable rather than two; it does not require the central bank to respond to real

variables potentially beyond its control; and by targeting nominal GDP the central

bank does not have to try to distinguish, in real time, between shocks to aggregate

The authors would like to thank two anonymous referees and the editor, Pok-sang Lam, for comments

on a previous draft.

DAVI D BECKWORTH is at the Mercatus Center at George Mason University (E-mail: dbeck-

worth@mercatus.gmu.edu). JOSHUA R. HENDRICKSON is at the Department of Economics of the University

of Mississippi (E-mail: jrhendr1@olemiss.edu).

Received October 4, 2015; and accepted in revised form December 3, 2018.

Journal of Money, Credit and Banking, Vol. 52, No. 1 (February 2020)

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2019 The Ohio State University

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supply and shocks to aggregate demand. Koenig (2012), however, argues that nominal

GDP targeting is just a special case of a Taylor Rule. If true, this implies that the

choice between nominal GDP targeting and the Taylor Rule is really just a choice

about the optimal parameters of a policy feedback rule.

In this paper, we argue that a comparison of a nominal GDP targeting rule and a

TaylorRule goes beyond the algebraic manipulation of a monetary policy rule, even if

it is assumed that the operating procedures of policy remain the same.1Our argument

is that the ability to algebraically manipulate a Taylor Rule to obtain a nominal GDP

targeting rule ignores critical informational differences between these two different

policy regimes. Nominal GDP is measured independently. Although it might be

subject to measurement error, targeting nominal GDP growth likely minimizes the

significance of this measurement error in real time. In contrast, measures of the

output gap require estimates of both real GDP and potential GDP. This is further

complicated by the fact that any real-time central bank estimate of potential GDP

is likely a function of observed past values of real GDP, which are also subject to

revision. This is problematic given the evidence that the Federal Reserve’s real-time

estimates of the output gap have, at times, systematically differed from the actual gap

(Orphanides 2000, 2002a, 2002b, 2004).2

Uncertainty about potential GDP implies that when monetary policy is modeled

for a central bank following a Taylor Rule, the analysis should include an equation

that describes how the central bank estimates potential GDP. This characteristic is

important because it suggests that errors in the central bank’s forecast of potential

GDP can be a potential source of business cycle fluctuations that would not exist

under a nominal GDP targeting rule. The basic idea is as follows. If the central bank

adjusts the nominal interest rate in response to its own imperfect estimate of the output

gap, there will be two types of monetary policy shocks. The first type is the traditional

shock that represents a deviation of monetary policy from its rule. The second type

is the forecast error of the central bank, which also causes the short-term interest rate

to deviate from the perfect information rule. Under a nominal GDP targeting regime,

policymakers need not worry about potential. Instead, changes in the trend of real

GDP over time will be reflected in higher or lower inflation rates consistent with

the central bank’s nominal GDP target. By relieving the central bank of the need to

estimate the output gap in real time, nominal GDP targeting can potentially reduce

economic fluctuations because it eliminates monetary shocks caused by forecast

errors.

The purpose of this paper is to argue that evaluating the desirability of a nominal

GDP targeting rule relative to a Taylor Rule requires that the actual information set

1. For an approach to nominal GDP targeting under different operating procedures, see Belongia and

Ireland (2015).

2. The problem of estimating the natural levelof output or the natural rate of unemployment is by now

well known. On the natural rate of unemployment, see Staiger, Stock, and Watson (1997) and Laubach

(2001). On the natural rate of output, see Orphanides and van Norden (2005) and Lansing (2002). As

a result, Staiger, Stock, and Watson (1997) and Orphanides and Williams (2002) argue that interest rate

rules should include changes in the unemployment rate rather than deviations from the natural rate. The

approach in this paper is to suggest nominal GDP targeting as an alternative.