The Case for Nominal GDP Targeting

The history of central banking is a story of one failure after another. This does not mean our actual monetary regimes have been the worst of all possible regimes—far from it. But it does mean 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 paper I argue that the optimal monetary rule is a nominal gross domestic product (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, it helps to see what went wrong with some previous monetary regimes and how past reformers responded to those failures.


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, both 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 the United States left the gold standard in 1933, the price level has gone up nearly 18 fold; a dollar in 2012 has less purchasing power than 6 cents in 1933. That sort of currency depreciation is almost impossible under a gold standard regime. Indeed, the cost of living in 1933 was not much different from what it was in the late 1700s. This 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 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.[2] 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 susceptible to periodic crises. They note wages and prices adjusted swiftly to the 1921 deflation, allowing a quick recovery, and countries with well-run banking systems, such as Canada, did even better. The big bone of contention is the Great Depression. Should that be blamed on the gold standard or meddlesome government policies?

My own research suggests that the answer to the preceding question is both.[3] But 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.[4] However, it is worth pointing out that governments also intervened during the classical gold standard, the period before World War I.

Advocates of gold often base their arguments for gold on the assumption that it is dangerous to give the government control over money. They claim it is much easier and more tempting for governments to debase fiat money than gold coins. That is true, but it does not mean a gold standard prevents meddlesome governments from creating instability in the short run, as in the 1930s. For instance, during the interwar years, major countries such as the United States and France often failed to adjust their money supplies to reflect changes in the monetary gold stock.

Here is how I see the debate today. Advocates of gold correctly claim that a gold standard will tend to preserve the value of money over long periods of time and will sharply reduce the ability of governments to extract wealth from savers. Critics are right that a real-world gold standard is likely to deliver unacceptably large short- term fluctuations in the price level. I think the critics are also correct in assuming that wages are much stickier than they were during the gold standard’s heyday and that the sort of deflation that led to just a brief surge in unemployment during 1921 (when wages quickly adjusted downward), might now lead to unacceptably high and persistent unemployment rates.[5] Yes, a “classical” gold standard could probably do considerably better than the sort of regime the United States had between the world wars, but if we could count on the authorities to accept the discipline of such a standard, why not instead make them obey rules forcing them to stabilize inflation or NGDP growth?

Obviously, this debate could go on to look at all sorts of political models of policy-making. Instead I am going to focus on purely technical issues. I would like to sketch out what I think are the pros and cons of various fiat money policy regimes and leave for others the public choice issues of whether such regimes are politically feasible. However, I will return to politics at the end, when I argue that NGDP targeting would help us avoid many extremely counterproductive government interventions in nonmonetary aspects of the economy. There are good reasons many economists (including some with libertarian leanings, like Friedrich Hayek)[6] have embraced some version of this policy target.

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