Nominal GDP targeting, real economic activity and inflation stabilization in a new Keynesian framework

Abstract

This paper examines a nominal GDP growth targeting (NGDP-GT) rule, two Taylor types of rules and a strict inflation targeting regime in a New Keynesian model with the assumption of a positive rate of trend inflation. The model adopts a trend total factor productivity (TFP) growth to compare monetary policies in both high and low growth environments. Policy rankings are affected by the level of trend growth, the level of partial indexation to inflation and different specifications of the Taylor rule. NGDP-GT either outperforms other regimes or is weakly dominated by a desirable policy. Specifically, from the stability perspective, NGDP-GT is preferred compared to a Taylor type of rule and a strict inflation targeting regime in stabilizing the economy. It reduces inflation volatility by 25% or more while performs almost as well in stabilizing output and consumption relative to the Taylor rule. It produces at least 27% less fluctuations in output and consumption, and is almost as well as inflation targeting in stabilizing inflation. From the welfare perspective, when the Taylor rule takes the simple form, inflation targeting is the least desirable framework and NGDP-GT is weakly dominated by the Taylor rule. The conclusions are not conditioning on the trend growth rate or the level of inflation indexation. However, if the Taylor rule takes the form that interest rate responds to deviations of inflation and output growth (TR-II), when a TFP shock hits the economy and trend growth rate A=1, TR-II generates of the least welfare loss and NGDP-GT performs almost as well. When trend growth rate A≠1, NGDP-GT is the most desirable policy regime. When the economy is subject to a markup shock, and A≥1 and (or) partial indexation to inflation η=1, TR-II dominates the other two regimes. For other cases, NGDP-GT is the desirable policy rule.