Rethinking monetary policy: The case for nominal GDP targeting

The monetary policy environment has changed considerably since the mid-twentieth century, from the development of economic thinking to the changes in policy priorities and the lessons learned from past experiences. Each transition, from the demise of the gold standard to floating exchange rates, monetary targeting and, more recently, the introduction of inflation targeting, has been a reactive response to the prevailing economic conditions of the time, whether driven by inflation, financial stability concerns, or geopolitical pressures. Despite these changes, the question must be asked: is there a better framework to ensure long-term price stability and economic growth?

Since the early 1990s inflation targeting has been at the heart of contemporary monetary policy. This regime aims to maintain price stability by keeping inflation close to a medium-term target, generally around 2 per cent annually. While widely adopted by central banks of advanced economies as the global standard, the limitations of this framework have been exposed by financial crises and supply-side shocks. Too often, central banks have underestimated the influence of fiscal policy and their own balance sheet expansions on inflation trends, contributing to monetary policy decisions that have added to the erosion of real incomes and exacerbated the cost-of-living crisis.

I believe we should have a fundamental rethink of the current monetary policy framework. Central banks should implement a framework that targets the growth rate or level path of nominal GDP (NGDP)¹ rather than relying on an inflation target of 2 per cent. NGDP targeting (NGDPT) offers a more transparent, rule-based approach that reduces subjectivity and the risk of policy errors by looking to stabilise total nominal spending in the economy. In contrast, the current ‘constrained discretion’² framework gives policymakers considerable flexibility (discretion) to react to fluctuating economic conditions within loosely defined parameters (constraints). By reducing reliance on discretionary decision-making, NGDPT would increase predictability and transparency for financial markets, thereby allowing central banks to regain any lost credibility.

NGDPT, also known as nominal income targeting, provides a more flexible and adaptive framework for managing external and supply-side shocks, such as the Covid-19 pandemic and energy price spikes, which contributed to driving inflation to its highest levels in four decades.³ I argue here that NGDPT is better equipped to maintain long-term economic stability by reducing fluctuations in output and employment more effectively. By reducing reliance on discretionary decision-making, NGDPT would provide a free-market approach to monetary policy and give households and firms clearer guidance on the future path of interest rates.

My objective is to demonstrate how an NGDPT-based framework could address the deficiencies of the current system. A key flaw of inflation targeting is its inability to distinguish between demand- and supply-driven inflation, leading to suboptimal policy responses during economic shocks. By advocating NGDPT, this article seeks to add to the broader debate on the future direction of monetary policy.

Inflation targeting was first introduced in New Zealand in 1990 (see Reserve Bank of New Zealand Act 1989), followed by Canada in February 1991, and the Bank of England in October 1992. This framework rests on two key pillars: (a) a flexible approach for discretionary responses to short-term economic shocks, and (b) a clear numerical objective for inflation to anchor expectations and ensure price stability. Although there are many different definitions of inflation targeting, the fundamental idea is that a forward-looking central bank is committed to maintaining inflation at a predetermined target, usually around 2 per cent, by conducting monetary policy through the interest rate channel.⁴

Changes to a short-term interest rate are the central bank's primary instrument, affecting aggregate demand to bring actual inflation into line with the inflation target. The underlying assumptions are that markets are flexible, that prices and wages adjust quickly to changes in monetary conditions, and that households and firms form rational expectations for both short-term and future inflation.⁵

By committing to a clear 2 per cent inflation target, policymakers provide a secure anchor for inflation expectations by lowering uncertainty regarding future price levels, at least over the medium term (see Gürkaynak et al., 2006; 2007; Ravenna, 2007). Firms are more confident when making medium- to long-term investment decisions thanks to this stability, and consumers are able to plan their spending and saving decisions more effectively.

Orthodox monetary policy suggests that central banks should initially ‘look through’ short-term inflation caused by adverse supply shocks, given their temporary impact on output.⁶ If central banks react too aggressively to such shocks, they risk amplifying economic volatility rather than stabilising it. Under ‘constrained discretion’, central banks can temporarily deviate from their rigid inflation target to support broader economic objectives such as employment and financial stability, although to what extent is subjective.

Despite some successes, inflation targeting has attracted a good deal of criticism for its rigidity and narrow focus, which often neglects other important macroeconomic variables, not to mention wider financial stability concerns. This limited scope may result in suboptimal policy decisions, especially during financial crises. Inflation targeting also ignores asset prices, particularly those of property and equities, which can result in asset bubbles, adding to the frequency of boom–bust cycles.

The debate over the best (and most agile) monetary system is continuing against a backdrop of an unstable macroeconomic climate, which includes very high levels of private and national debt, chronically low productivity growth in some economies, deglobalisation, and an ageing population with associated social care costs. Furthermore, we are currently experiencing a period of increased geopolitical tensions.

One measure that has gained popularity in recent years is NGDPT. By focusing on real output and inflation, NGDPT aims to stabilise overall economic growth rather than the rate of inflation. A fundamental principle in the creation of monetary policy is the requirement for a quantitative anchor: a baseline that guides market expectations and policy actions. According to Fatás et al. (2007), stability and predictability in monetary policy depend on a reliable anchor, be it inflation, the money supply, or another measure.

According to Frankel (2012), NGDPT offers a more balanced approach to managing economic volatility, since it naturally adapts to both supply- and demand-side shocks. Under this approach, monetary policy will permit some deflationary pressure if output increases and productivity rises, but will tolerate higher-than-target inflation to support recovery during a downturn when growth is below the desired target.

Although some economists and central bankers find this framework to be an appealing alternative, this has not yet become the consensus view, despite growing attention in policy and media circles. Furthermore, to date, it has not been adopted by any central bank. Its slow acceptance in scholarly discussions reflects concerns about practical applicability, especially with respect to data accuracy, policy transmission, and public understanding. However, with recent crises exposing shortcomings in inflation targeting, and with many economies flirting with stagnation and therefore a renewed focus on growth, NGDPT should be re-evaluated as a viable alternative to inflation targeting.

NGDP targeting traces its intellectual origins to early proponents such as Meade (1978), Tobin (1980), Bean (1983), and Gordon (1985) – although others argue its roots lie in the work of Hayek and Austrian economics (see Evans, 2016). It emerged as a compelling alternative to the post-war Keynesian consensus, with its strong focus on demand management, and to the monetary targeting policies of the 1970s, particularly due to its ability to counteract velocity shocks (i.e. shifts in money demand) (see Beckworth, 2019).

The debate between rule-based and discretionary approaches to monetary policy has regained attention recently, particularly after the criticisms of policy responses following the Covid-19 pandemic. Rules (intermediate targets) act as nominal anchors for central banks, committing them to implement consistent policies. Advocates of a rule-based approach, such as Kydland and Prescott (1977), argued that although discretionary policies may address immediate issues such as unemployment, they often result in ‘inflationary bias’ and greater long-term economic instability.

Discretionary inflation bias, as described by Kydland and Prescott (1977) and Barro and Gordon (1983), arises when central banks attempt to stimulate employment above its natural level by surprising markets with inflation. However, this approach typically leads to higher inflation without reducing unemployment, and weakens central bank credibility. When policymakers deviate from their commitments to react to short-term conditions, they risk undermining trust, which can lead to elevated inflation expectations among market participants and greater inefficiencies in wage and price setting.

Such time-inconsistency problems – where policymakers deviate from pre-committed policies for short-term gains – affect both monetary and fiscal policy decisions. When investors anticipate policy deviations, they demand higher yields on government debt, increasing borrowing costs and contributing to fiscal inefficiencies. Inconsistent policies can also lead to ‘stabilisation bias’, resulting in greater volatility in inflation and economic output, increasing uncertainty and complicating long-term business planning. Therefore, rules are preferable to discretion in monetary policy.

Proponents of NGDPT argue that its rule-based approach enhances predictability and transparency, while providing a countercyclical mechanism to counter recessions and booms, and reducing the risk of destabilising inflation bias. This systematic approach minimises uncertainty and allows market participants better to anticipate central bank actions. By contrast, the current system of constrained discretion has been criticised for its lack of clarity. The delayed response of central banks to rising inflation in 2021, initially downplayed as ‘transitory’, demonstrates how discretionary policies can lead to suboptimal outcomes.

No single monetary policy framework can comprehensively manage the complexities of a contemporary economic system. Inflation targeting, as in previous regimes, should not be seen as permanent. Its sole focus on one macroeconomic variable is a design flaw that no longer makes it the optimal anchor for monetary policy.

I have tried in this article to demonstrate the relative effectiveness of NGDPT as a compelling alternative to inflation targeting for conducting monetary policy: how it can better accommodate both supply-side and demand-side shocks, how it automatically incorporates economic growth into monetary policy decisions, and its ability to deal with the zero lower bound. All of these make it a serious alternative option for strengthening the monetary policy framework and supporting sustainable long-term financial and economic stability.

Additionally, by providing a clear and transparent approach to monetary policy while preserving central bank independence, NGDPT would increase central bank credibility. However, implementing such a transition requires careful consideration of practical challenges, particularly related to communication and data accuracy.

Central banks should move towards a monetary system that reduces dependence on discretionary policymaking. NGDP targeting represents a critical step in that direction, but the ultimate goal should be a framework where market forces, not bureaucrats, determine the supply of money.

Reserve Bank of New Zealand Act 1989. https://www.legislation.govt.nz/act/public/1989/0157/82.0/DLM199364.html (accessed 5 May 2025).