Taylor Rules and NGDP Targets: Skeptical Davids

One of the big, current, passionate debates within monetary policy is the relative effectiveness of Taylor Rules versus nominal GDP targeting (e.g. see here). Which of the two does a better job of stabilizing the economy?

If you want to argue against nominal GDP targeting, David Altig of the Atlanta Fed has some ammunition for you. Here's his conclusion:

Nominal GDP Targeting: Still a Skeptic, macroblog: ... To summarize my concerns, the Achilles' heel of nominal GDP targeting is that it provides a poor nominal anchor in an environment in which there is great uncertainty about the path of potential real GDP. As I noted in my earlier post, there is historical justification for that concern.

Basically, anyone puzzling through how demographics are affecting labor force participation rates, how technology is changing the dynamics of job creation, or how policy might be altering labor supply should feel some humility about where potential GDP is headed. For me, a lack of confidence in the path of real GDP takes a lot of luster out of the idea of a nominal GDP target.

Taylor rule skeptics can turn to David Andolfatto of the St. Louis Fed:

On the perils of Taylor rules. macromania: In the Seven Faces of "The Peril" (2010), St. Louis Fed president Jim Bullard speculated on the prospect of the U.S. falling into a Japanese-style deflationary outcome. His analysis was built on an insight of Benhabib, Schmitt-Grohe, and Uribe (2001) in The Perils of Taylor Rules.

These authors (BSU) showed that if monetary policy is conducted according to a Taylor rule, and if there is a zero lower bound (ZLB) on the nominal interest rate, then there are generally two steady-state equilibria. In one equilibrium--the "intended" outcome--the nominal interest rate and inflation rate are on target. In the other equilibrium--the "unintended" outcome--the nominal interest rate and inflation rate are below target--the economy is in a "liquidity trap."

As BSU stress, the multiplicity of outcomes occurs even in economies where prices are perfectly flexible. All that is required are three (non-controversial) ingredients: [1] a Fisher equation; [2] a Taylor rule; and [3] a ZLB.

Back in 2010, I didn't take this argument very seriously. In part it was because the so-called "unintended" outcome was more efficient than than the "intended" outcome (at least, in the version of the model with flexible prices). To put things another way, the Friedman rule turns out to be good policy in a wide class of models. I figured that other factors were probably more important for explaining the events unfolding at that time.

Well, maybe I was a bit too hasty. Let me share with you my tinkering with a simple OLG model... Unfortunately, what follows is a bit on the wonkish side...

[My comments on this topic are highlighted in the first link, i.e. the one to David Altig's post at macroblog.]