This post follows up on an observation I made in my post about George Selgin’s recent criticism of John Taylor’s confused (inasmuch as the criticism was really of level versus rate targeting which is a completely different issue from whether to target nominal GDP or the price level) critique of NGDP targeting. I found Selgin’s discussion helpful to me in thinking through a question that came up in earlier discussions (like this) about the relative merits of targeting NGDP (or a growth path for NGDP) versus targeting nominal wages (or a growth path for nominal wages).
The two policies are similar inasmuch as wages are the largest component of nominal income, so if you stabilize the nominal wage, chances are that you will stabilize nominal income, and if you stabilize nominal income (or its growth path), chances are that you will stabilize the nominal wage (or its growth path). Aside from that, the advantage of NGDP targeting is that it avoids a perverse response to an adverse supply shock, which, by causing an increase in the price level and inflation, induces the monetary authority to tighten monetary policy, exacerbating the decline in real income and employment. However, a policy of stabilizing nominal income, unlike a policy of price level (or inflation) targeting, implies no tightening of monetary policy. A policy of stabilizing nominal GDP sensibly accepts that an adverse supply shock, by reducing total output, automatically causes output prices to increase, so that trying to counteract that automatic response to the supply shock subjects the economy to an unnecessary, and destabilizing, demand-side shock on top of the initial supply-side shock.
Here’s Selgin’s very useful formulation of the point:
[A]lthough it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.”
The question I want to explore is which policy, NGDP targeting or nominal-wage targeting, does the better job of minimizing departures from what Selgin calls the “full-information” level of output. To simplify the discussion let’s compare a policy of constant NGDP with a policy of constant nominal wages. In this context, constant nominal wages means that the average level of wages is constant, any change in a particular nominal meaning an equivalent change in the relative wage. Let’s now suppose that our economy is subjected to an adverse supply shock, meaning that the supply of a non-labor input has been reduced or withheld. The reduction in the supply of the non-labor input increases its rate of remuneration and reduces the real wage of labor. If the share of labor in national income falls as a result of the supply shock (as it typically does after a supply shock), then the equilibrium nominal (as well as the real) wage must fall under a policy of constant nominal GDP. Under a policy of stabilizing nominal wages, it would be necessary to counteract the adverse supply shock with a monetary expansion to prevent nominal wages from falling.
Is it possible to assess which is the better policy? I think so. In most employment models, workers accept unemployment when they observe that wage offers are low relative to their expectations. If workers are accustomed to constant nominal wages, and then observe falling nominal wages, the probability rises that they will choose unemployment in the mistaken expectation that they will find a higher wages by engaging in search or by waiting. Thus, falling nominal wages induces inefficient (“involuntary”) unemployment, with workers accepting unemployment because their wage expectations are too optimistic. Because of their overly-optimistic expectations, workers’ decisions to accept unemployment cause a further contraction in economic activity, inducing a further unexpected decline in nominal wages and a further increase in involuntary unemployment, producing a kind of Keynesian multiplier process whose supply-side analogue is Say’s Law.
So my conclusion is that even nominal GDP targeting does not provide enough monetary stimulus to offset the contractionary tendency of a supply shock. Although my example was based on a comparison of constant nominal GDP with constant nominal wages, I think an analogous argument would lead to a similar conclusion in a comparison between nominal NGDP targeting at say 5 percent with nominal wage inflation of say 3 percent. The quantitative difference between nominal GDP targeting and nominal wage targeting may be small, but, at least directionally, nominal wage targeting seems to be the superior policy.