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Expectations and NGDP Targeting: Supply-Side Problems with Demand-Side Policy

This paper points out an underappreciated difficulty with proposals for macroeconomic stability that rely on targeting nominal variables, including price level targeting and the now-popular NGDP targeting. These proposals, in line with a dynamic conception of the Quantity Theory, argue that the monetary authority can achieve any dynamic monetary equilibrium, provided favorable public expectations. However, it is precisely the problem of public expectations that cannot be assumed away. Because the public will only find a subset of dynamic monetary equilibria attainable, attempts to coordinate around an equilibrium perceived to be unobtainable will have unintended consequences. Attempts at demand-side stabilization policy will instead result in supply-side difficulties. This point, well-understood by economists working during the era of stagflation, has seemingly been forgotten in the post-financial crisis Keynesian resurgence. We caution against reverting to demand-side fundamentalism as a consequence of the crisis and propose a more fruitful framework.