The Case for a Nominal Gdp Target Level

Issue No: 11/41 Nov 1, 2011

The Case for a Nominal GDP Target Level

Goldman Sachs: US Economics Analyst Oct 14, 2011

Goldman Sachs prepared this case study in attempt to persuade fiscal policy to target nominal GDP levels back to 2007 trends where employment was close to full potential. This article was chosen in part because it covers most chapters in the second half of the semester and brings to life terms, theories and practices studied to date. While our economy has slightly improved through the lowering of interest rates to near 0%, economist state that through additional asset purchases nominal GDP will recover back to trend over time.

To fully grasp the concept of this study, GDP and nominal GDP must be defined. GDP is the measure of the market or money value of all final goods and services produced by the economy in a given year. However we cannot measure the market year to year if the value of money changes in response to inflation and deflation. This is a problem because the value of GDP is determined by multiplying total output by market prices. The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall. This shows how the economy has increased or decreased over a period of time. A GDP based on the prices in a certain year is nominal GDP.

In the Goldman Sachs study, 2007 market prices were used as the base or nominal GDP. According to economist GDP has fallen by 10%, roughly 20 trillion dollars, between 2007and 2011. Economic analyst agree that the easiest way to return to 2007 GDP trends would be to keep federal funds rates low as long as needed and use large-scale asset purchases. While this theory sounds plausible it will require a lot of money and the faith of the public to pull off, neither of which the United States possesses at this time.

While a shift to a nominal GDP level target is clearly a big decision, it is consistent with current mandates to pursue maximum employment and low inflation. After all, nominal GDP is equal to the price of the level multiplied by real GDP, and real GDP in turn is very closely related to employment via "Okuns Law" (GS Research, 2011). The nominal GDP shift is also consistent with the Taylor Rule, which is a monetary policy used by the central bank to change nominal interest rates in response to inflation. In particular the rule states that for every 1% of inflation the nominal interest rate should raise by more than 1 %. The nominal GDP target differs from the Taylor rule for two reasons. The first is the nominal GDP target prices enter as a level while the Taylor rule enters as a rate of change. The advantage of a price level target is that it reduces the uncertainty about future price levels. This is a major advantage as the American people have felt the strain of rising prices over the last year. According