The Argument for Targeting NGDP in Developing Countries

August 5, 2014
By Doug Gavel

Central bankers in developing countries face a difficult challenge. While carrying out their primary charge of setting national monetary policy, they typically must speak in terms of a single economic variable if they are to communicate their intentions simply and clearly. In a new Harvard Kennedy School Faculty Research Working Paper, Professor Jeffrey Frankel argues that central bankers in middle-sized middle-income countries should target Nominal Gross Domestic Product (NGDP), as opposed to targeting the nation's money supply, exchange rate, or inflation.

"The problem with these [other] approaches to monetary-policy targeting is that even though a particular numerical target may be reasonable when it is set, subsequent unexpected developments often make the target hard to live with," Frankel argues. "The monetary authorities are then confronted with a harsh choice between violating their announced target, and thus undermining the credibility that was the point of the exercise, or setting policy too tight or too loose, thus doing unnecessary damage to the economy."

Frankel says that the need among emerging and developing economies to establish policy credibility is critical. "They need targets with which they can live," Frankel writes.

He argues that, by targeting nominal GDP, central bankers are "not faced with a choice between abandoning the target and hurting the economy."

"There are good reasons to think that NGDP targeting is better suited to emerging and developing economies than to industrialized countries," Frankel concludes. "These economies are more frequently subject to adverse terms-of-trade shocks, such as increases in world oil prices or declines in prices for their commodity exports. Their economies also tend to suffer larger supply shocks from natural disasters, other weather events, social unrest, and unexpected productivity changes." NGDP targeting is designed to survive such fluctuations; the alternatives are not, he explains.

The article, titled, "Nominal GDP Targeting for Middle-Income Countries," is posted on the Harvard Kennedy School Faculty Research Working Papers website.

Jeffrey A. Frankel is James W. Harpel Professor of Capital Formation and Growth. He directs the Program in International Finance and Macroeconomics at the National Bureau of Economic Research, where he is also on the Business Cycle Dating Committee, which officially declares recessions. He served at the Council of Economic Advisers in 1983-84 and 1996-99; as CEA Member in the Clinton Administration, Frankel's responsibilities included international economics, macroeconomics, and the environment.

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Jeffrey Frankel, James W. Harpel Professor of Capital Formation and Growth

Jeffrey Frankel, James W. Harpel Professor of Capital Formation and Growth

Photo Credit: Martha Stewart

"The problem with these [other] approaches to monetary-policy targeting is that even though a particular numerical target may be reasonable when it is set, subsequent unexpected developments often make the target hard to live with."