Scott Sumner is rightfully put off by this assertion

Greg Ip refers us to this excellent paper from Laurence Ball which shows that targeting NGDP is a pretty lousy idea. One can see immediately that Ball must be spot on from that fact that none of the usual suspects, Scott Sumner or Nick Rowe for example, has even acknowledged the existence of the paper even though Nick actually did a post responding to Ip’s article!

from Canucks Anonymous

First, I outlined this concern over a year ago when I wrote

However, the case for supporting a target for Nominal GDP is by no means open and shut. There are at least four reasons why this is the case, two academic and two practical. I will begin with the academic.

First, instability. It is at least a theoretical possibility that Nominal GDP target could lead to instability because prices and output do not respond at the same time to a single action by the Fed.

Suppose that we enter a credit bubble where nominal spending expands rapidly as credit risk is underpriced. Such a bubble would show up as a rise in Nominal GDP. The Fed would respond by tightening the money supply.

Tightening would have the immediate impact of raising unemployment and bringing real GDP down. Nominal GDP would fall as well and the Fed will meet its target.

Over the next 18 months, however, the rate of inflation would trend down in response to tightening. This would lead the Fed to loosen money. Unemployment would fall, Nominal GDP would expand and the Fed would hit its target.

However, over the next 18 months, the rate of inflation would trend up wards in response to looser money. The Fed would tighten money. Unemployment would rise, Nominal GDP would fall and the Fed would hit its target.

However, over the next 18 months . . .

This process could in theory continue indefinitely. The Fed is hitting its target every time but because the same policy instrument effects the different parts of Nominal GDP at different times a permanent instability is induced. Both unemployment and inflation are high in one period. Both unemployment and inflation are low in the next. Nominal GDP is stable but the variables of interest are not.

There are perhaps ways of combating this but we should be aware of the risk.

This essentially the logic of Larry Ball’s paper and the Market Monetarist went to great lengths to explain why this wasn’t an issue.  I wasn’t completely satisfied but this is a technical matter that can be avoided by either choosing different instrument or by altering the way you use the interest rate instrument.

I don’t have time to do this non-technically so let me just say that the issue here that the structure of the policy instrument, fed response and economic response are such that you can generate a standing wave.

One could kill the standing wave by altering the phase of any of these factors. Fed response is the one you would choose.

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